Municipal Bond Yield Spread at Record High
10 yr AAA Municipal bonds are currently yielding around 4.95%. This is 32% HIGHER than the 10 yr Treasury note which is yielding 3.74%. Most of the time municipal bonds offer lower interest rates compared to Treasuries because of their tax favored status.
To see how unusual the current situation is here is a plot of 20yr Municipal yields versus 10yr Treasury Notes going back to 1962. I used the different terms because that allowed me to go back farther in history.
- Inflation risk — The longer the maturity the greater the risk that a period of high inflation will come along and eat away at the value of the bond. Of course, Treasuries have this same risk.
- Default risk — In the short term, with the decline in real estate and the recession, municipal tax receipts are going down. There is likely to be a default or two in particular cities and townships. However, as far as I know, no state has ever defaulted on its general obligation municipal bonds. So short term credit risk can probably be dealt with it by carefully selecting your bond issues (i.e., stick with state general obligation bonds). In the longer term, I see more risk as the pension obligations start to really bite into municipal budgets.
- Pricing risk — Municipalities will have to raise a lot of money over the next few years. If the federal government doesn’t provide some form of bailout to help allay fears in this arena, yields could go up even further as supply outstrips demand.