Ratios of municipal to Treasury bond yields over the past three months have shown a degree of volatility that has complicated a standard valuation of tax-exempt debt for investors.

After rocketing higher for much of the last two months of 2011 — the 10-year muni yield peaked at 118% of the equivalent Treasury on Nov. 23 —  ratios have fallen back in the new year as muni bonds have outperformed Treasuries.

Now that ratios have come in — a triple-A rated 10-year muni was paying 91% of the equivalent Treasury bond on Jan. 17 — are munis still the attractive buy that they were when ratios were higher?

Muni pros say that it’s harder to find value in the 10-year range, where the muni rally has been strongest. But farther out on the curve, around the 20-year range where ratios are still considered attractive, lies the best value for investors.

Looking at the last three months, ratios today look rich, said Dexter Torres, principal and head trader on the portfolio management team at Samson Capital Advisors.

But compared with the last five to 10 years, he added, today’s ratios look closer to their historic average.

“You could also say that, given the low-rate environment, people are reaching for a little bit more yield,” Torres said, “and hence, going farther out the curve as well.”

Current ratios also remain high in historical terms though they remain below levels reached at the height of the financial crisis in 2008, when Treasury yields plunged as investors flocked to safety.

Low supply has been a major factor in the municipal bond market for months now and it’s accurate to say that munis’ value will be a function of supply going forward, according to Peter DeGroot, a muni strategist with JPMorgan.

If supply continues to be restrained moving through the first quarter, muni yields will likely continue to outperform.

“Should we see an aggressive uptick in supply, then naturally ratios would rise from that point,” he said.

Muni-Treasury ratios have long represented an important measure the industry uses for gauging the value of tax-exempt bonds. The higher triple-A-rated muni yields are relative to Treasury yields, measured as a percentage, the more attractive municipal bonds are relative to Treasuries.

Typically, a muni-Treasury ratio north of 100% means that investors receive the tax benefit of muni bonds for free, making them even more attractive for high-net-worth investors. By extension, as the ratios fall, munis become more expensive relative to Treasuries.

Since the late 1980s, the 10-year muni ratio has averaged around 83%, meaning that the muni rate has been below the Treasury rate. In that range, investors in the highest tax brackets could still get value buying munis through their inherent tax-exemption, even though they were paying more than they would for equivalent Treasuries to get them.

During the financial crisis, ratios for the 10-year triple-A shot into the stratosphere, soaring above 100% in mid-September 2008 and pretty much remaining there through April 2009.

The ratio reached 186% on Dec. 18, 2008, its highest level in at least 30 years.Recent ratios in the 90% range more closely resemble historical numbers.

The average 10-year muni-Treasury ratio over the past 10 years was 89.4% as of mid-January, according to Samson Capital, using numbers compiled from JPMorgan.

During the last five years it has increased to 92.6%, and was 91.0% for the last two years. The average for 2011 stood at 97.4%.

As the European debt crisis dominated the headlines late last year ratios shot higher as demand for U.S. Treasury bonds climbed.

Still, most retail investors ignore ratios. Instead, DeGroot said, when it comes to deciding on munis, they focus on capital preservation and the generation of tax-exempt income, as well as their perception of the future performance of higher beta assets.

But institutions and high-net-worth individuals use ratios to determine the richness or cheapness of munis to Treasuries. Retail investors might go out to 15 years on the curve, said John Hallacy, municipal research strategist at Bank of America Merrill Lynch. “But it’s more often the high-net-worth individual, rather than a mom-and-pop type investor, who will go longer,” he said.

And crossover buyers use ratios in their search for value. They typically show more interest in munis as ratios rise. But extremely low absolute yields and a pronounced lack of supply, more than ratios, have been the guiding factors for the muni market of late, industry experts say.

Thus, ratios for 10-year triple-A general obligation bonds haven’t necessarily been considered attractive to investors once they crossed the 100% threshold.

To investors, the nominal rates and the supply-demand imbalance in the market have been taking precedence in their decision-making.

Still, one of the biggest moves and best values lies with the 20-year triple-A muni, as well as with longer muni maturities, said Philip Condon, head of municipal bond portfolio management at Deutsche Bank DWS Investments.

Yields for the 20-year have declined 72 basis points since late November, or from 3.51% to 2.79%, according to Municipal Market Data. Its ratio has also remained cheap, hewing closely to the 30-year triple-A. For all of last year, the 20-year bond averaged almost 109%, about where the 30-year stood.

In the fourth quarter, ratios for both the 20-year and the 30-year averaged about 122%. And for 2012 through Jan. 17, the 20-year ratio has averaged 112%, while the 30-year averaged 114%.

“There is less value in the 10-year range,” Condon said. “But the muni yield curve is still steep, and longer bonds have the best value. The light supply, which is typical from late November to mid-January, and the recent increase in retail demand for long muni funds have helped flatten the muni curve.”

But supply, the market’s driver, is expected to pick up next month, municipal bond pros have said. And when it does, ratios should start to move higher once again, though not to recent levels, said Bart Mosley, co-president at Trident Municipal Research as well as a principal at Alprion Capital Management.

“If ratios correct as supply picks up over the next few weeks, after the post-New Year’s lull,” he said, “we won’t see it as a sign that we’re heading back to the cheap 110%-to-120% 10-year ratios of late last year.”

 James Ramage writes for The Bond Buyer.


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