What is the MOB spread?-- Sidney J. Friedman Sidney, There you go
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.
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.
|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|