Municipal investors often pay close attention to the relative value of municipal bonds by comparing municipal yields to the yields of other types of bonds. The most common comparison is versus Treasury bonds. Taking the AAA municipal bond yield in each tenor and putting that over the corresponding Treasury yield will provide a ratio.

This Municipal/Treasury yield ratio (M/T Ratio) is usually a key figure in assessing the overall relative value of municipal bonds. The range which the M/T Ratio has traded over the past few years is noticeably lower than historical averages and warrants attention from bond investors as this shift lower may be here to stay. 

Where have municipal bonds traded historically?

For much of the past 30 years, the M/T Ratio has averaged between 80 percent to 90 percent across much of the Intermediate yield curve and even higher on the longer end of the curve. Looking back 10 to 12 years ago, ratios often traded well above that average for extended periods (See Figures 1 and 2). 

Around that time, politicians on both sides of the aisle proposed to curtail or limit the tax-exempt nature of income on municipal bonds. During those years, it was not uncommon for the M/T Ratio to trade above 100%. In other words, the AAA municipal bond yield was higher than Treasury bond yields at the same maturity, even though the yield on the municipal bond was tax-free¹ whereas the Treasury yield was federally taxed. Often the call from municipal prognosticators was, ‘You’re getting the muni exemption for free!”

In early 2024, that’s no longer the case. 

Over the past few years, even though absolute municipal bond yields are more attractive due to an overall increase in interest rates, the M/T Ratio has steadily declined. This largely reflects low supply, steady demand, and more recently, the potential for higher tax rates and a shift in municipal ownership toward less ratio-sensitive buyers. In late 2023 and early 2024, M/T Ratios have touched (or come close) to new lows. (See Figure 3). 

What affects muni relative value?

Both short- and long-term trends influence M/T Ratios.

In the short-term, “seasonality” effects and tax risk can contribute to ratio movement. For example, in January and July, supply tends to wane and demand tends to wax. Both January and July feature notable upticks in maturity and coupon cash flow reinvestment. M/T Ratios sometimes fall in those months, although not in January 2024, as M/T Ratios rose modestly due to increased supply following a remarkably swift move downward in yields in the final weeks of 2023. 

Tax risk can also alter the relative value of munis over a brief time. For example, during the first half of 2013, following an Obama administration proposal to curb the tax-exemption, the AAA muni yield curve often traded above the Treasury curve (i.e., the M/T Ratio was above 100% across the curve) (See Figure 4). The same phenomenon occurred in the months prior to the Tax Reform Act of 1986. Of note, tax-exempt supply might increase over the next few months in 2024 if issuers decide to refinance more Build America Bonds (BABs).² A near-term surge in BABs refinancings would reflect a recent change in issuers’ understanding of when they can legally refinance BABs, which are a creature of the internal revenue code. In short, when tax risk is elevated, investors want to be compensated.

Over the long term, structural changes to the composition of supply and demand can influence the trading range for M/T Ratios. The market is experiencing such changes today, pressuring M/T Ratios lower. 

On the supply side, three trends have biased ratios lower for over a decade. 

First, municipal issuance has been tepid. Issuers avoided borrowing in the 2010 to 2016 period to repair their balance sheets in the aftermath of the Great Financial Crisis (GFC), based on data reported by The Bond Buyer. (See Figure 5.)

Second, in 2017, Congress passed the Tax Cuts and Jobs Act (TCJA). That law prohibits tax-exempt advance refundings,³ which had comprised as much as 20 percent of new issue supply, annually. Municipal issuance declined, as shown by data reported by The Bond Buyer. (See Figure 6.)

Third, Treasury supply has grown dramatically relative to municipal supply. In 2010, there was $2 worth of marketable Treasuries outstanding for every $1 of municipal debt. Today, the same figure is $6.30 for every $1 of municipal debt.⁴ This pattern implies that Treasuries are abundant relative to municipals (or, in reverse, that municipals are scarce relative to Treasuries). Regardless of how one thinks about it, this fact should pressure M/T ratios downward.

Figure 7 underscores this idea. While debt in other fixed income markets has grown since the GFC, the muni market has not kept up.

On the demand side, buyers are also accessing the market in ways that pressure ratios downward. As illustrated below, over the past two years two investor segments have grown at a faster clip while two other cohorts have declined as a proportion of market ownership. Specifically, households (of which Breckinridge SMAs are a part) and Exchange Traded Funds (ETFs) have become a larger part of the buyer base (See Figure 8). Banks, insurance companies, and mutual funds have seen their ownership decline. This shift has buoyed municipal demand, as households and ETFs are often steadier buyers of municipals than banks or insurance companies or tactical-oriented mutual funds.

It’s also true that secular demand for municipals remains intact. The aging retail investors who constitute 71 percent of municipal demand are a growing demographic. These buyers are sensitive to the possibility that Congress may raise marginal income tax rates to close federal deficits. They tend to prefer bonds with lower default risk and volatility (such as municipal bonds) compared with other options. (For more detail, see Breckinridge’s 2024 Municipal Market Outlook.)

Could M/T Ratios Get Back to a Higher Range?

It’s possible, but we believe it is unlikely, in the near-term. We hope to see a modest increase in ratios from current levels, but a shift towards longer-term historical averages is unlikely in the near term. Smaller fluctuations in supply and demand throughout the course of a year seem more plausible. In our opinion, it is now more important to be attuned to these shifts given the lower M/T Ratio regime. 

An uptick in tax risk could shift the M/T Ratio higher. With an ever-growing fiscal deficit, Congress might consider taxing muni interest. That could bias ratios upward. (For more detail, see Breckinridge’s 2024 Municipal Market Outlook.) But as it stands today, market pricing reflects little concern for this risk. In our view, this makes good sense. Lawmakers are much more likely to raise marginal tax rates or trim the size of the tax-exempt bond market (e.g., by eliminating private activity bonds) than they are to tax muni interest on existing bonds. Both of these changes would bias ratios lower, not higher.

What’s an investor to do?

Investors should prioritize flexibility when it comes to buying tax-exempt versus taxable bonds. A tax-exempt bond will not always be the most tax-efficient investment in today’s market (See Figure 9). Even for an investor in a mid- to top-tier tax bracket, a taxable bond will sometimes be the best purchase, on an after-tax basis, when M/T Ratios break away from historical norms as illustrated previously.

At Breckinridge, we believe a prudent approach to managing a Tax-Efficient portfolio now requires the ability to purchase both taxable and tax-exempt bonds, depending on market conditions. Breckinridge’s tax efficient strategies invest primarily in tax-exempt municipal bonds but are also designed to allow taxable bonds when the after-tax math warrants. 

Thoughtful duration management is also now more important. Sound duration management can reduce the amount of reinvestment in a municipal bond strategy, and potentially help a client capture tax-free income for longer periods of time. For instance, when primary market issuance slows in the summer months, it may become prudent to reduce the amount of reinvestment by aligning portfolios appropriately around a strategy’s duration target. This can better align reinvestments with periods when historically supply has been higher and reinvestment demand from other investors has been lower.

Sourcing bonds in the secondary market is now more important, as well, especially when the primary market lags. The secondary market is an additional source of supply for investors. Navigating it requires significant resources, acumen, and dealer relationships. At Breckinridge, we toggle between both markets throughout the course of the year as opportunities and relative value dictate. In this new regime of lower M/T ratios and large primary oversubscription, we have found the opportunity within the secondary market to be valuable (See Figure 10⁵). 

Ultimately, whether M/T Ratios are trading at 60 percent or 100 percent, at Breckinridge, our mission for our Tax-Efficient strategies is to build portfolios of the highest caliber with bonds that offer compelling relative value from an after-tax, risk-adjusted income perspective.

[1] Income from municipal bonds is generally free from federal taxes and taxes in the state in which the bond was issued.

[2] Build America Bonds (BABs) were taxable municipal bonds that featured federal tax credits or subsidies for bondholders or state and local government bond issuers. Build America Bonds (BABs) were introduced in 2009 as part of President Obama's American Recovery and Reinvestment Act (ARRA) to create jobs and stimulate the economy. The Build America Bonds program expired in 2010.

[3] An advance refunding occurs when the refunded bonds are redeemed more than 90 days from the date the refunding bonds are issued, and an irrevocable escrow account is established to make payments until the call date of the bonds. Unlike a current refunding, an advance refunding typically requires a prepayment penalty which issuers often factor into anticipated savings. Note that changes to federal tax law in 2017 eliminated the ability of governments to issue tax-exempt bonds for an advance refunding of outstanding tax-exempt debt. The goal of the change was to eliminate the ability of issuers to have two sets of tax-exempt bonds issued for the same initial capital funding purpose outstanding at the same time, for example, during the escrow period before the refunded bonds are called. Governments are still allowed to issue taxable debt to advance refund tax-exempt debt; however, issuers often consider and evaluate the higher interest cost relative to tax-exempt bonds.

[4] Breckinridge calculations based on Federal Reserve Data.

[5] The chart depicts the percentage on a dollar basis of the total volume of trades for all Breckinridge tax-exempt bond strategies completed weekly on the primary market and the secondary market from January 2, 2018 through December 31, 2023. The source of the data was Breckinridge’s trading records.

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