Municipal ersus Treasury onds: The Relationship

ROLF E. LUNDELIUS, PHD, CFA Quantitative Analyst

Municipal Versus Treasury Bonds: The Relationship

Seeking Value in Municipal Credit Spread

The Municipal Desk continues to find value for the crossover investor in municipal credit spread. This note uses the historical relationship between AAA municipal and Treasury rates (the "Relationship") to interpret current market levels.

As of March 18, 2015, the ratios of AAA municipal yields to Treasury yields are currently 92%, 106% and 114% for the 5-, 10- and 30-year maturity points, respectively. Ratios exceeding 100% strongly suggest value, especially for those investors that can benefit from tax-exempt income.

Ratios greater than 100% are predicted by a long-term linear regression model when Treasury yields are unusually low.

Municipal bonds may provide protection from rising rates because they exhibit long-term betas to Treasury bonds ranging from 68% (for the 5-year maturity) to 60% (for the 30-year maturity).

Closer analysis reveals evidence of positive convexity in the Relationship at low rate levels. Historical data suggests that municipal yields diverge from the long-term linear model when rates are very low and cluster around the 100% ratio line. The historical relationship suggests that municipal bonds will appreciate with a beta of 1.0 if Treasury rates decline, but will revert to lower betas if Treasury rates rise.

Risk, Risk Premium and Valuation

Linear regression provides important information about the municipal market. The graphs below show scatter analyses of municipal and Treasury yields for three maturity points.

Exhibit 1

Tsy 5 vs MMD 5

5-Year Treasury vs. 5-Year Municipal BondAspr(M19M91Dto*)F,eAb p20r1il51991 to February 2015

7 y = 0.6823x + 0.3765 R? = 0.9633

6

5-Year AAA MMD Rate (%)

5

4

3

2

1

0

0

1

2

3

4

5

6

5-Year Treasury Rate (%)

Source: Bloomberg, Thomson Reuters, Western Asset. As of 18 Mar 15

MMD5 Mar 2014 to Feb 2015 100% Ratio 3/18/2015 Linear (MMD5)

7

8

9

*Municipal Market Data

? Western Asset Management Company 2015. This publication is the property of Western Asset Management Company and is intended for the sole use of its clients, consultants, and other intended recipients. It should not be forwarded to any other person. Contents herein should be treated as confidential and proprietary information. This material may not be reproduced or used in any form or medium without express written permission.

Municipal Versus Treasury Bonds: The Relationship

Exhibit 2

Tsy10 vs MMD 10

10-Year Treasury vs. 10-Year MMD, April 1A9p9r119t9o1FteobFeruba20ry152015

7

6

y = 0.6514x + 0.8338 R? = 0.9557

10-Year AAA MMD Rate (%)

5

4

3

2

1

1

2

3

4

5

6

10-Year Treasury Rate (%)

Source: Bloomberg, Thomson Reuters, Western Asset. As of 18 Mar 15

Exhibit 3

Tsy30 vs MMD 30

30-Year Treasury vs. 30-Year MMD, April 1A9p9r119t9o1FtoebFerbua20r1y52015

8

7

30-Year AAA MMD Rate (%)

6

5

4

3

2

1

0

2

3

4

5

6

30-Year Treasury Rate (%)

Source: Bloomberg, Thomson Reuters, Western Asset. As of 18 Mar 15

MMD10 Mar 2014 to Feb 2015 100% Ratio 3/18/2015 Linear (MMD10)

7

8

9

y = 0.6033x + 1.6665 R? = 0.8785

MMD30 Mar 2014 to Feb 2015 100% Ratio 3/18/2015 Linear (MMD3 0)

7

8

9

The table below summarizes the regression results for the 5-, 10- and 30-year maturities. Recall that the beta coefficient represents proportional change in municipal yield given a change in Treasury rates, and the constant coefficient is a municipal risk premium earned by the investor.

Exhibit 4 AAA MMD Regressed on to Treasury Rates

Maturity 5-Year 10-Year 30-Year

Beta

Constant

R-Sq

0.682

0.377

0.96

0.651

0.834

0.96

0.603

1.667

0.88

Source: Bloomberg, Thomson Reuters, Western Asset. As of 18 Mar 15

Western Asset

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April 2015

Municipal Versus Treasury Bonds: The Relationship

This table suggests that, given the right entry level, municipal bonds could provide protection from rate increases while earning a stable risk premium.

The regression model also provides a rich/cheap model to evaluate municipal yields in terms of Treasury yields. Using levels from March 18, 2015, we find that the 5- and 10-year municipal yields are 4 and 6 basis points (bps) rich, respectively. The 30-year point is 35 bps rich according to the linear model, yet has a ratio of 114% and a positive spread of 34 bps over Treasury yields.

Exhibit 5 Regression Model for March 18, 2015

5-Year 10-Year 30-Year

Treasury Predicted AAA MMD

Err

Err Z-Score Ratio

1.389

1.324

1.28

-0.044

-0.10

92

1.921

2.085

2.03

-0.055

-0.23

106

2.511

3.181

2.85

-0.331

-1.00

114

Source: Bloomberg, Thomson Reuters, Western Asset. As of 18 Mar 15

Spread -0.109 0.109 0.339

Low Rates

One of the recurring questions regarding municipals is whether ratios should or do increase when rates decrease. The studies above indicate that ratios have increased in low rate environments, and recent history has provided us an opportunity to observe detailed behavior at the extremes of low rates. In particular, if municipal yields continue to track the regression line, then sufficiently low rates will lead to ratios that exceed 100%. The graphs above include the 100% ratio line shown in green, and, when Treasury rates are low, the data points cluster around the green line segments (albeit with errors). It appears that the market resists ratios above 100%, and the long-term regression relationship is broken at extremely low rates.

This represents a type of positive convexity. Near the point of intersection of the green and black lines on the graph, history suggests that municipals will lag Treasury bonds with a beta of 0.60 (for the 30-year point) if rates increase, but will keep pace with Treasury bonds if rates decrease.

Past results are not indicative of future investment results. This publication is for informational purposes only and reflects the current opinions of Western Asset Management. Information contained herein is believed to be accurate, but cannot be guaranteed. Opinions represented are not intended as an offer or solicitation with respect to the purchase or sale of any security and are subject to change without notice. Statements in this material should not be considered investment advice. Employees and/or clients of Western Asset Management may have a position in the securities mentioned. This publication has been prepared without taking into account your objectives, financial situation or needs. Before acting on this information, you should consider its appropriateness having regard to your objectives, financial situation or needs. It is your responsibility to be aware of and observe the applicable laws and regulations of your country of residence. Western Asset Management Company Distribuidora de T?tulos e Valores Limitada is authorized and regulated by Comiss?o de Valores Mobili?rios and Banco Central do Brasil. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business, investment management, and Type II Financial Instruments Dealing business with the registration number KLFB (FID) No. 427, and members of JIAA (membership number 011-01319) and JITA. Western Asset Management Company Limited ("WAMCL") is authorized and regulated by the Financial Conduct Authority ("FCA"). In the UK this communication is a financial promotion solely intended for professional clients as defined in the FCA Handbook and has been approved by WAMCL.

Western Asset

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April 2015

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