What's the Municipal Over Bond (MOB) Spread?

What is the MOB spread?

-- Sidney J. Friedman

Sidney,

There you go again -- always asking the questions so many are dying to know the answers to, but too proud to ask. You are the sworn enemy of fixed-income ignorance! I salute you.

Ah, the MOB spread. Takes me back to my Bond Buyer days, when the Internet was mewling and puking in the nurse's arms and the Treasury yield curve was positively sloped. ( The Bond Buyer, where I was a reporter for a couple of years, is the daily newspaper of the municipal bond market, and the M in MOB stands for municipal.)

So, what is the MOB spread? MOB stands for municipal over bond.

The MOB spread is the difference in price between the municipal bond futures contract listed on the Chicago Board of Trade and the Treasury bond futures contract listed on the same exchange. The muni futures contract is the "municipal" in MOB, and the Treasury contract is the "bond."

The CBOT lists various muni and Treasury contracts, with different expiration dates. Unless otherwise specified, the contracts involved in the MOB spread are the ones that are closest to expiration, without being less than a month from expiration.

The futures contracts roughly track the underlying markets. When the Treasury market is going up in price (when yields are falling), the Treasury futures contract generally also rises. Same with the muni contract.

Thus, the MOB spread rises and falls based on the relative performance of the Treasury and municipal bond markets. When munis are outperforming Treasuries, the muni contract will rise more (or fall less) than the Treasury contract, the MOB spread will rise or widen. Conversely, when the Treasuries are outperforming munis, the MOB spread will fall or narrow.

To profit from a rising MOB spread, a trader would pair a long position in the muni contract with a short position in the Treasury contract. Even if both contracts went down in price, as long as the muni contract outperformed the Treasury contract the trade would be profitable. Conversely, to profit from a falling MOB spread, a trader would pair a short position in the muni contract with a long position in the Treasury contract. Because of its speculative nature, MOB trading is done mainly by professionals.

Obviously, the key question is: Why would munis ever outperform Treasuries, or vice versa?

To understand the movements of the MOB spread, you need to know a bit more about the two contracts. The Treasury contract tracks the price of a 30-year Treasury bond (though not necessarily the most recently issued, or "on-the-run," 30-year). The muni contract tracks the price of an index of muni bonds -- the Bond Buyer Municipal Bond Index.

Interest rates are a major cause of shifts in the MOB spread. That is because the Treasury bond tracked by the Treasury futures contract is noncallable. By contrast, most muni bonds are callable, meaning that the issuer has the right to return the investor's principal and cease all interest payments at some point before the bond matures. Issuers of callable bonds call them when interest rates fall, so that they can issue new bonds at lower rates.

When interest rates fall, noncallable bonds outperform callable bonds. A noncallable bond's price will keep rising as rates fall, because the bond's interest rate will exceed the rates available on new bonds by a widening margin. Meanwhile, a bond that is at risk of being called will stop rising at a certain point. Because if the bond is called, the investor will be faced with the prospect of reinvesting at lower interest rates. So when interest rates fall, the MOB spread typically falls as the Treasury contract outperforms the muni contract.

As you can see from this chart, the massive bond rally from mid-1997 to late 1998 was accompanied by a steep decline in the MOB spread.

The MOB Spread The price of the municipal bond futures contract, minus the price of the Treasury bond futures contract

Source: Chicago Board of Trade

Changes in the muni index can also cause shifts in the MOB spread. The index is regularly reconfigured to incorporate newly issued munis and kick out older bonds. The makeup of the index determines how it will respond to changes in interest rates. Older bonds are less rate-sensitive than newer ones, and lower-quality bonds are less rate-sensitive than higher-quality ones. So changes in the pace of new issuance and in the average quality of new issues can affect the MOB spread.

Finally, the MOB spread responds to goings-on on Capitol Hill, which grants the exemption from federal income tax that most municipal bonds offer. The value of the tax exemption to the wealthiest taxpayers, based on their marginal tax rate, determines how much lower than a taxable interest rate the interest rate on a municipal bond can be. So any movement to alter the tax code can affect the performance of municipal bonds relative to taxable Treasuries, and thus affect the MOB spread.