At one point near the end of July, using data from Bloomberg, the 10-year Treasury note was yielding 1.47% and 10-year AAA-rated municipals were yielding a virtually identical 1.46%.
From a tax perspective, given their federal tax exemption (and for most residents buying their own state’s bonds, a local tax exemption as well) we would expect municipals to trade at significantly lower yields.
For example, if there were no additional risks in owning municipals, and assuming a 40% marginal tax rate (the effective rate can be much greater for high-bracket investors), we would expect a municipal bond of the same maturity to trade with a yield 0.59 percentage points lower than the Treasury yield of 1.47% (or at just 0.88%). Thus, there must be other explanatory factors.
Two Drivers Of Muni Bond Spreads
Today we’ll take a closer look at the two other drivers of the municipal-to-Treasury spread.
The first, and most obvious, is credit risk. While there have been some significant default losses in municipal bonds, the historical record shows that for municipal bonds rated AAA (that also are either general obligation bonds or essential service revenue bonds), credit losses have been very close to zero—just a few basis points a year. This was true even during the Great Depression.
As another example that credit spreads don’t provide much explanatory power for high-quality municipal bond spreads, we can look at what are called prerefunded bonds.
Prerefunded bonds are created by municipalities that precommit to the early exercise of an existing bond and to then issuing a new bond. Proceeds from the new bond issue are placed into a trust containing Treasurys, which pays the remaining obligations of the existing bond up until the original call date.
The U.S. Treasury issues special bonds, called state and local government securities (SLGS, or “slugs”), especially for the purpose of advance refunding. And the original municipal bond now has the same credit quality as a Treasury bond. Yet these bonds tend to trade at only slightly lower yields (approximately 2 to 5 basis points) than municipal bonds without the credit enhancement. There must be another factor, and that remaining factor is liquidity.
Liquidity Is A Risk Factor
As Andrew Ang, Vineer Bhansali and Yuhang Xing, authors of the study “The Muni Bond Spread: Credit, Liquidity, and Tax,” explain: “Liquidity premiums arise when securities with identical credit and other risks but with different turnover, price impact, volume, or other liquidity characteristics trade at different prices.”
Because the tax impact on yield is large, and there have not been significant credit losses for the highest-quality bonds, nor do we find much of an impact on yield when bonds are backed by the full faith and credit of the U.S. government (as with prerefunded bonds), we can see that municipal bonds spreads are highly impacted by a liquidity premium.
In fact, Ang, Bhansali and Xing found that since the global financial crisis of 2008, liquidity has played a major and long-lasting role in determining municipal bond spreads.
Shifting Liquidity Premium
In their study, which covered the period 1995 through 2013, they found that “most of the changing level of the muni yield spread before and after the financial crisis comes from a shifting liquidity premium: the liquidity component changes from 0.82% before 2008 and more than doubles to 2.14% after 2008.” Following is a summary of their findings:
- More than 90% of the variation in muni spreads is attributable to time-varying liquidity components. The credit component accounts for only 4% of the variation in the muni yield spread after 2008, and the attribution of the variance in the muni spread to the tax component is even lower, at 2%.
- Municipal bond credit and liquidity components exhibit strong covariation with credit and liquidity factors in other asset classes.
- Innovation in municipal bond credit components is significantly related to contemporaneous changes in credit spreads in the corporate bond markets, and the municipal bond liquidity component increases when price impact and bid/ask spreads increase in stock markets.
Reduced Liquidity, Higher Yields
The first month or so following issuance, most municipal bonds tend to trade very infrequently, perhaps once a month, or even less frequently; thus, they tend to be illiquid. And since the financial crisis, banks have dramatically reduced assets committed to their bond trading activities, decreasing liquidity in the municipal bond market.
It shouldn’t be a surprise, then, that liquidity premiums have widened. The result is that municipal bond yields are higher than they would have been if liquidity had not been reduced.
The bottom line is that for investors who can bear liquidity risk (because for them it is not a major risk, at least in some portion of their portfolio), the reduced liquidity in the market makes municipal bonds more attractive.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.