Municipal Bonds vs. Treasury Bonds Yield Gap: Liquidity Risk

In my personal portfolio, I’ve been investing in tax-exempt municipal bonds instead of treasury bonds due to their higher taxable-equivalent yields. If you’ve done the same, you may be interested to know that Larry Swedroe at Advisor Perspectives argues that the reason for this yield spread is not credit risk, but liquidity risk.

After the first month or so following issuance, most municipal bonds tend to trade very infrequently, perhaps once a month or even less frequently. Thus, they are illiquid. Since the financial crisis, banks have dramatically reduced assets committed to their bond-trading activities, decreasing liquidity in the municipal bond market. It shouldn’t be a surprise, then, that liquidity premiums have widened. The result is that municipal bond yields are higher than they would have been if liquidity had not been reduced.

Many investors can bear liquidity risk, because they buy individual bonds with the intent of holding them to maturity. For them liquidity is not a major risk, at least in some portion of their portfolio; the reduced liquidity in the market makes municipal bonds more attractive.

The spread itself has been narrowing, according the chart below tracking the ratio of AAA-rated GO Muni bonds to Treasuries over the last 12 months (not adjusted for taxes). Taken from the most recent Baird’s weekly muni commentary.

Still, muni bond funds remain relatively attractive for many folks, especially in higher tax brackets. Use this Vanguard taxable-equivalent yield calculator and compare the numbers for your own situation.

Bottom line. My takeaway is that muni investors should acknowledge this liquidity risk, and be prepared for short-term swings in muni bond fund prices (due to illiquidity) if there is a major event (like a surprise bankruptcy filing). However, if you are truly a long-term holder of muni bonds, then you can accept this risk, hopefully ride things out, and be compensated with higher tax-equivalent yields.