Treasury bonds are noncallable debt instruments issued by the federal government with a maturity of more than 10 years. they pay interest twice a year and pay back principal at maturity. Contrary to municipals, Treasury bonds are considered free of default. Thus, the differences in expected returns come from differences in maturity, liquidity, tax implications, and tax provisions.
Municipal (muni) bonds, on the other hand, are often callable, and have tax-free interest (however, this is not the case for capital gains). Muni bonds are issued by cities, counties, airport authorities, or other nonfederal political entities. Generally, they are either obligation bonds backed by the credit/taxing power of the issuer, or revenue bonds backed by the financed project or the respective operating municipal agency.
Because munis are tax-free, they sell at lower yields than nonmuni bonds with the same risk and maturity. Thus, in order to compare munis with Treasuries, we must first estimate a taxable equivalent yield by comparing the discounted cashflows before-tax and after-tax.
If the yield curve is flat and munis and Treasuries sell at par, the tax-equivalent yield can be approximated by dividing the muni yield by 1 minus the marginal tax rate. Consequently, changes in tax exemption rules will affect the performance of muni bonds relative to Treasury bonds, as well as the MOB spread.
Interest rate shit s may also af ect the MOB spread. For example, if interest rates fall, the muni bond issuer can call the bonds back and issue new ones at a lower interest rate. Thus the price of munis tends not to rise beyond a certain point.
On the other hand, the price of Treasury bonds will increase as interest rates fall, because they are noncallable. Consequently, the MOB spread will generally decrease as Treasuries outperform munis, and vice versa.
The sensitivity of the MOB spread to changes in interest rates depends on the makeup of the underlying index. This sensitivity increases with the time to maturity and the bond quality. Changes in the construction of the underlying will also result in changes in the MOB spread.
Betting on the spread is popular because it is relatively easy to predict. For example, it is easier to predict the relative development of changes in interest spreads because of consistent seasonal patterns of certain spreads. Predicting the general direction of interest rates is more difi cult.
And demand for taxfree municipal debt relative to demand for Treasury debt is more predictable because of the state taxation system. thus, if a trader expects muni bonds to outperform Treasury bonds, he will buy muni bond futures contracts and short Treasury bonds.
|Municipals Over Bonds Spread (MOB Spread)|