From Roberto Roffo at SWBC Bank:
There is a lot of talk these days regarding the ratio of AAA municipal bond yields and similar maturity treasury yields. Those yields currently range from approximately 60% on the short end of the curve to 91% on the long end of the curve and can fluctuate from rich to cheap based on the long-term average of the spot on the curve. While the long end is currently relatively cheap and the short end is slightly rich, the quoted ratios don’t tell the story of how cheap municipal bonds really are across the entire curve.
While municipal bond to treasury ratios fluctuates from rich to cheap, stepping down in credit rating almost always results in substantially cheaper tax-free yields.
Buying AA or A rated municipal bonds only increases risk by .01% over the life of the bonds.
Tax equivalent yields for AA and A rated municipal bonds are significantly cheaper than Treasury yields.
The same strategy works well regardless of which part of the yield curve desired.
Considering the historical safety that municipal bonds offer, it’s very easy to move slightly down the rating spectrum from AAA to A rated bonds and purchase bonds yielding significantly over similarly dated treasury bonds, with very little added risk. According to a recent JP Morgan report (guide to the markets A/O 06/30/2023) the default rate of A rated municipal bonds is approximately 0.1% versus 2% for corporate bonds. An investor that is still worried about the 0.1% can stick with the larger and liquid A rated issuers and lower the risk even more.
Long-term investors who purchase AAA rated bonds in 30 years can increase the ratio at which they purchase their bonds from 91% to approximately to 115% of 30-year treasuries while adding a minuscule amount of risk. Analyzing the yields both on a tax-free basis and a tax-equivalent basis showcases the true value of slightly lower rated municipal bonds.
For example, if an investor purchases a 30-year AAA bond at a tax-free yield of 3.90% versus a 30-year A rated bond at a 4.80% not only are they adding an additional 90 basis points of yield, the resulting tax equivalent yield is substantially more. For investors in the top income bracket the tax-equivalent yields are 6.45% for the AAA bond and 7.95% for the A rated bond, an increase of approximately 150 basis points in tax-equivalent yield. While not totally risk free, that is a significant amount of additional yield for a 0.1% default rate in a $4 Trillion market.
The example above is not only indicative of the long end of the curve which is currently relatively cheap. It also can be applied to portions of the curve that are relatively rich to treasuries to purchase bonds that offer more value compared to AAA municipal bonds and treasury bonds, while increasing both tax-free and tax-equivalent purchase yields.