Swedroe: Understanding Muni Bond Spreads

Munis are on a tear, but do most investors truly understand their risks and rewards?

The municipal bond market has almost $4 trillion in total debt outstanding. That compares with about $18 trillion in outstanding U.S. Treasury debt. Besides market size, municipal bonds differ from Treasurys in that they carry credit risk, are less liquid and are exempt from federal income tax.

The size of the spread between Treasury bonds and municipal bonds is determined by the variation in one or more of those three differences. To investigate the municipal bond spread, the authors of a 2014 study—“The Muni Bond Spread: Credit, Liquidity, and Tax”—split it into its components.

They examined the credit component of the spread by comparing returns to municipal bonds that have been prerefunded and backed by Treasurys. Such bonds are considered to be riskless from a credit standpoint.

To examine the liquidity component, the authors compared the “risk free” (prerefunded) municipal bond yields with the after-tax yields on Treasurys. While default risk and liquidity risk serve to increase municipal bond yields, the tax advantages of municipal bonds serve to shrink the muni spread.

The study covered the period 1995-2013. Following is a summary of the authors’ findings:

• The muni yield spread exhibits a regime change before and after the 2008 financial crisis.
• While the global financial crisis roiled many security markets, its effects in muni markets have been longer lasting.
• Pre- and post-2008, the credit component didn’t change very much. It went from 0.4 to 0.6 percent. Nor did the tax component, which moved from -2.1 to -1.8 percent.
• More than 90 percent of the variation in muni spreads is attributable to time-varying liquidity components. Post-2008 saw the liquidity premium increase 160 percent in relative terms, from about 0.8 to about 2.2 percent.
• The credit component accounts for only 4 percent of the variation of the muni yield spread after 2008 and the tax component accounts for an even lower 2 percent. Note that during this period, the highest marginal tax rates were relatively stable. They were at a low of 35 percent between 2003 and 2012, and a high of 39.6 percent in 1996 and again in 2013. Of course, the higher the tax rate, the more negative the spread.
• Muni credit and liquidity components exhibit strong co-variation with credit and liquidity factors in other asset classes. Innovations in muni credit components are significantly related to contemporaneous changes in credit spreads in corporate bond markets, and the muni liquidity component increases when price impact and bid/ask spreads increase in stock markets.
• Prerefunded yields are “too high” because they are less liquid than regular munis. In a given transaction, bond prices move more for prerefunded munis. The average price impact measure for prerefunded bonds is 0.687, which is significantly higher than the price impact measure of 0.368 for regular munis.

An explanation for the limited impact of credit spreads is that, between 1970 and 2009, there were only four defaults on debt issued by towns, cities or counties, and only 54 defaults of municipal entities.

The average five-year historical cumulative default rate was just 0.03 percent, versus approximately 1 percent for investment-grade corporate issuers. Recovery rates on defaulted municipal bonds are also higher than recovery rates on defaulted corporate issues.

The findings are an important reminder to investors that while high-quality municipal bonds (AAA/AA and also either general obligation or essential service revenue bonds) are relatively good substitutes for Treasurys in terms of credit risk, they do not provide the same hedging qualities as Treasurys when there are liquidity shocks.

On the other hand, municipal bond investors who don’t need liquidity benefit from the liquidity premium built into municipal bond prices.

Larry Swedroe is the director of research for the BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.