Municipal bonds had a spectacular performance in 2011. Now investors want to know whether last year’s shining returns can be repeated, or whether the mechanics of the bond market suggest that most of the gains for the asset class have already been made.
Muni yields are touching 45-year lows. Everyone wants muni bonds, but the supply has been very limited. The chart above maps the Bond Buyer 20-Bond GO Index, which is based on an average of certain general obligation municipal bonds maturing in 20 years with an average rating of Aa2 and AA. It’s a widely used general municipal bond index, and we can see that it is now hovering around 4 percent. Municipal bond yields have not been this low since the middle of the 1960s. It’s very hard to judge the direction of the market when it has been such a long time since similar conditions prevailed.
The chart below is a much more sophisticated way to view the municipal market relative to the Treasury market. What the chart depicts is the spread of 10-year Treasury bonds over the Thomson Reuters Municipal Market Data 10-year AAA benchmark. Demand for municipal bonds has been so strong that they are trading at a lower yield than the equivalent Treasury bond: The Thomson Reuters MMD 10-year AAA yield was 1.67 percent on Wednesday, versus a yield of 1.89 percent on the 10-year US Treasury.
Regarding recent trading conditions, Daniel Berger of Thomson Reuters MMD said: “Secondary trading was not as grabby as past sessions, which could signal some reservation at current historically low yields.” To translate Dan, the low yields and high cost of municipal bonds relative to Treasuries is cooling off some traders’ interest. This makes sense looking at how strong the market has been since early October. But if we look at the very long horizon in the first chart, there might be room for municipal yields to go as low as they were in the 1950s and ’60s. When a market is this hot, caution is a good idea. When the market signals are this strong, it’s good to pay attention.