The Muni-Treasury Ratio: Definition and Explanation
One way to assess the value of municipal bonds is to compare their yields to those of U.S. Treasuries. Be wary, though: this comparison is only a rough guide, not one that will provide hard-and-fast rules, or indicate a definite move towards or away from one or the other.
First, let’s look at the math behind the ratio. Fortunately, it’s simply the yield on AAA-rated municipal bonds (munis) relative to the yield on a U.S. Treasury of similar maturity. If the yield on AAA munis is 1.5% and the yield on the 10-year Treasury is 2.0%, the ratio is 0.75.
Muni-Treasury Ratio = Municipal Bond Yield ÷ 10-Year Treasury Yield
The higher the muni-Treasury ratio, the more attractive munis are relative to Treasuries. Throughout history, the ratio has averaged about 0.8. The yields on municipal bonds are typically lower than those of Treasuries because the interest in munis is tax-exempt, whereas the interest on Treasuries is taxable. Therefore, investors generally require higher yields to invest in Treasuries.
A number of factors impact what the muni-Treasury ratio is at any given time. The first factor is the base level, which is the average of the tax rates for municipal investors.
Here’s why: assume the muni-Treasury ratio is .75. At that level, an investor in the 25% bracket receives the same after-tax yield on municipals and Treasuries. Also, assume that munis yield 3% and Treasuries yield 4%. The Treasuries investor receives an after-tax yield of 3% (4% x .75), so the yield on the two bonds is equal.
Over time, the two markets should reach an equilibrium based on the average tax rate of the investor base as people make buy and sell decisions based on their after-tax yields.
Unfortunately, it isn’t that clean in real life. Other factors that go into determining the actual ratio include:
- The fact that munis are less liquid (i.e., less easily traded) than Treasuries, which affects pricing.
- The two markets have distinct supply-and-demand dynamics. In past years, for instance, municipal bonds were supported by the combination of higher-than-normal demand and below-normal new supply, which helped boost their prices relative to Treasuries.
- The investor base in the two markets is also quite different. The Treasury market tends to have a higher representation of short-term traders, whereas the muni market is dominated by longer-term investors. As a result, municipal bonds often move more slowly than Treasuries, which in turn affects the ratio.
- The muni-Treasury ratio also reacts to expectations for future tax rates—not necessarily what the rates are at that moment.
Since the 2007-2008 financial crisis, the muni-Treasury ratio has been well above its historical average. The primary reason for this is the aggressive policies of the U.S. Federal Reserve (the Fed) designed to fuel economic recovery, which included ultra-low interest rates and quantitative easing.
Together, these policies have resulted in Treasury yields that are well below the levels they would have been without the Fed’s influence. In turn, the low yields have caused the muni-Treasury to rise above typical levels and reach as high as 120%—a level that was unheard of prior to the crisis.
Putting It All Together
The muni-Treasury ratio is one tool investors can use to assess the value of municipal bonds. However, so many factors affect the ratio that it should always be considered in conjunction with the broader investment picture. Further, it’s important to keep in mind that municipals can still produce a negative return when the ratio is high.
This is because a downturn in Treasury prices is likely to be accompanied by a similar downturn in municipals (keep in mind, bond prices and yields move in opposite directions). A good rule of thumb to follow is that it's better to choose your investments based on your own goals and objectives, rather than basing decisions on market conditions.