The municipal market has started off 2019 in a strong way, with tax-exempt municipal bonds now trading at some of the richest valuations versus taxable bonds on record. Driven by robust demand (as measured by mutual fund inflows) and light supply (as measured by new issuance), the positive technical environment has been one of the main drivers of the rally.
To measure the relative value of tax-free munis versus taxable bonds, we often analyze the ratio of municipal yields versus Treasury yields. As shown in the chart below, this ratio has dropped over the past 12 months, particularly for short to intermediate maturities such as five and ten years.
While there are no immediate signs of this trend reversing, these absolute yield levels have created an opportunity for crossover investors to sell munis, purchase taxable bonds, and increase the after-tax yield generation on their portfolios. For example, the after-tax yield for investors in a mid-level tax bracket is 0.19% higher on a 1-year US Treasury Note as compared to a 1-year AAA municipal bond.
The after-tax yield advantage is even more dramatic for corporate and taxable municipal bonds, which carry additional yield because of a credit spread premium.
These relationships are particularly relevant for our Blend Strategy, which has the leeway to invest in a mix of taxable and tax-free bonds. After increasing our allocation to tax-free municipals in the winter of 2017 during a muni market sell-off, we’ve been slowly capturing municipal outperformance by selling munis and buying taxable bonds. We executed on another leg of this trade last week as the after-tax yield opportunity has become too good to ignore.
Source: Barclays, Bloomberg