At one point near the end of July 2016, using data from Bloomberg, the 10-year Treasury note was yielding 1.47% and 10-year AAA-rated municipals were yielding a virtually identical 1.46%. From a tax perspective, given their federal tax exemption (and for most residents buying their own state’s bonds, a local tax exemption as well) we would expect municipals to trade at significantly lower yields.

For example, if there were no additional risks in owning municipals versus Treasury bonds and assuming a 40% marginal tax rate (the effective rate can be much greater for high-bracket investors), we would expect a municipal bond of the same maturity to trade with a yield 0.59 percentage points lower than the Treasury yield of 1.47% (or at just 0.88%). Thus, there must be explanatory factors other than the favorable tax treatment of municipal bonds.

Today we’ll take a closer look at the two other drivers of the municipal-to-Treasury spread.

The first, and most obvious, is credit risk. While there have been some significant default losses in municipal bonds, the historical record shows that for AAA-rated municipal bonds (that also are either general obligation bonds or essential service revenue bonds), credit losses have been very close to zero – just a few basis points a year. This was true even during the Great Depression.

As another example that credit spreads don’t provide much explanatory power for high-quality municipal bond spreads, we can look at what are called pre-refunded bonds. Pre-refunded bonds are created by municipalities that pre-commit to the early redemption of an existing bond and to then issuing a new bond. Proceeds from the new bond issue are placed into a trust containing Treasury securities, which pays the remaining obligations of the existing bond up until the original call date.

The U.S. Treasury issues special bonds, called state and local government securities (SLGS, or “slugs”), especially for the purpose of advance refunding. The original municipal bond has the same credit quality as a Treasury bond. Yet, these bonds tend to trade at only slightly lower yields (approximately two to five basis points) than municipal bonds without the credit enhancement.

There must be another factor, and that remaining factor is liquidity.

Liquidity Is a risk factor

As Andrew Ang, Vineer Bhansali and Yuhang Xing, authors of the study “The Muni Bond Spread: Credit, Liquidity, and Tax,” explained: “Liquidity premiums arise when securities with identical credit and other risks but with different turnover, price impact, volume, or other liquidity characteristics trade at different prices.”

Because the tax impact on yield is large, and there have not been significant credit losses for the highest-quality bonds, nor do we find much of an impact on yield when bonds are backed by the full faith and credit of the U.S. government (as with pre-refunded bonds), we can see that municipal bonds spreads are highly impacted by a liquidity premium. In fact, Ang, Bhansali and Xing found that since the global financial crisis of 2008, liquidity has played a major and long-lasting role in determining municipal bond spreads.

In their study, which covered the period from 1995 through 2013, they found that “most of the changing level of the muni yield spread before and after the financial crisis comes from a shifting liquidity premium: the liquidity component changes from 0.82% before 2008 and more than doubles to 2.14% after 2008.” The following is a summary of their findings: