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Dow Jones S&P 500 NASDAQ 10-Year Note
10,441.12 1,109.18 2,206.91 35.96
Oil *
73.55
DOWN
10.88
UP
1.25
UP
5.86
DOWN
0.07
10 Yr
3.60%
SPDR Gold
111.59
-0.10%
+0.11%
+0.27%
-0.19%
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Commentary: Futures Shock
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Getting Involved With the MOB
By Howard Simons
Special to TheStreet.com
5/9/01 11:34 AM ET



If you can't beat 'em, join 'em.

Anyone who was watching the recent budget debates in Washington had to come away shaking their head with the sad realization that those guys don't have to play by the same rules as the rest of us. Whether the economy rises or falls, the government's take -- state and local as well as federal -- just keeps on rising.

Maybe George Orwell missed a little on his apocalyptic vision of 1984, unless you want to count credit rating agencies data-mining your purchase patterns as Big Brother, but he sure got it right in Animal Farm: Some are more equal than others.

This column's unceasing advocacy of self-reliance in economic life -- if you really think an industry's gouging you, buy its stock rather than waste your breath complaining -- extends to Uncle Sam and his 50 nephews as well.

In the absence of widow-and-orphan stocks (Oh yeah? Name one!) and with the ever-decreasing maturity of corporate bonds, municipal bonds may represent one of the last great reservoirs of pricing power in the modern economy. State and local governments are shielded from the forces of competition and can raise their prices (taxes) at rates far greater than their productivity can expand.

The big advantage for municipal bond investors is, of course, exemption from federal taxation on qualified issues; the bonds normally are exempt from being taxed in their home state as well. Of course, since we are dealing with taxation issues, life is never simple, and there are issues involving amortization and accrual of bonds purchased at premiums and discounts, respectively. In addition, municipal bonds issued to finance private projects may be subject to the dreaded Alternative Minimum Tax.

Given all of this, are there investment opportunities in buying municipals, especially in a spread against Treasuries? The so-called municipal-over-bond spread can be executed easily and effectively via the Chicago Board of Trade's futures contracts on Treasuries and on the Bond Buyer's 40-member municipal bond index.

MOB History

Over the generally bullish bond markets of the past decade, Treasuries have outperformed municipal bonds. As a result, Treasury yields have fallen below those of municipals for much of the time since 1998, producing a negative MOB spread. Treasury bonds typically yield more than municipal bonds; the equivalent taxable yield of a municipal bond is its yield divided by (1 - [marginal tax rate]).

The negative MOB, while unusual, is neither unprecedented nor inexplicable. It happened during the 1994 bear market in bonds and just prior to the onset of the 1999 bear market in bonds.

A Kindler, Gentler MOB

The ongoing Treasury buyback of long-term bonds has kept the municipal-over-bond spread negative nearly continuously since August 1999. A notable aberration occurred in January 2001, when the market briefly pushed the MOB spread toward 70 basis points in anticipation of Bush tax cuts. This rally was negated quickly, and the MOB is once again negative.

First, the large number of private activity revenue bonds subject to the alternative minimum tax makes a marginal tax rate difficult to determine, but it may place the real marginal tax rate well over the statutory rate. Second and similar, the phase-out of Schedule A exemptions raises the effective marginal rate as well. Third, the IRS can challenge all municipal issues' tax status at any time, and this requires greater yield protection.

In addition, many municipal issues are callable, whereas Treasuries are not. This lowers the bonds' yield to worst and injects an element of negativity into the calculations.

And, as the recent downgrade of California bonds as a result of the electricity debacle reminds us, the credit risk of municipal bonds is considerably greater than that of Treasuries. Finally, Treasuries have a permanent liquidity advantage to munis, and this advantage becomes especially pronounced during bond bear markets like 1994. Put it all together, and the convergence of Bond Buyer index and Treasury yields doesn't seem so out of line.

If the Fed's loosening continues through its May 15 meeting, which appears likely given the weak employment report of May 4, the yield curve will continue to steepen and stocks will continue to outperform bonds.

Eventually, as noted in this space last week (see Waiter! There's A Bear In My Bonds! , a vicious bond bear market could emerge. This will make the trade of selling municipal bonds and buying Treasuries even more attractive. You could do this trade with the Chicago Board of Trade futures while keeping your tax-advantaged muni bonds and muni bond funds. Some trades are more equal than others.

Howard L. Simons is a professor of finance at the Illinois Institute of Technology, a trading consultant and the author of The Dynamic Option Selection System. Under no circumstances does the information in this column represent a recommendation to buy or sell securities. While Simons cannot provide investment advice or recommendations, he invites you to send your feedback to Howard Simons.

TheStreet.com has a revenue-sharing relationship with Amazon.com under which it receives a portion of the revenue from Amazon purchases by customers directed there from TheStreet.com.

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Sorry, the page you requested could not be found

Sorry that you couldn't find the page you wanted.

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Content Search:

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Dow Jones S&P 500 NASDAQ 10-Year Note
10,441.12 1,109.18 2,206.91 35.96
Oil *
73.55
DOWN
10.88
UP
1.25
UP
5.86
DOWN
0.07
10 Yr
3.60%
SPDR Gold
111.59
-0.10%
+0.11%
+0.27%
-0.19%
Data delayed 20 minutes

More From TheStreet

Latest Headlines