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The Crossover Trade: When Tax Free Isn’t Always Tax Efficient

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Nisha Patel, CFA

Managing Director

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Fixed income investors should keep a close eye on the tax implications of the muni-to-Treasury ratio. A crossover trade may prove useful—and our quiz might prove insightful.

For investors in the highest federal tax bracket, tax-free municipal bonds have generally offered the highest after-tax returns compared with other high-quality investments, such as US Treasuries. This has been largely true through various US tax regimes. However, investors shouldn’t assume this is always the case.

We interpret the relationship between AAA-rated munis and Treasuries as a ratio of tax-exempt yields to Treasury yields. One might expect the ratio would be a simple function of the tax rate. For example, if the tax rate were 35%, a AAA-muni-to-Treasury ratio of 65% would make the equation a wash. But the reality is more complex.

The value of the crossover trade 

Certain factors, such as supply and demand or volatility in the Treasury market, may shift muni-to-Treasury ratios significantly. The ratio for a five-year AAA muni bond has averaged 83% over the past 10 years, with a minimum ratio of 38% (February 2021) and a maximum ratio of 623% (March 2020). The minimum and maximum ratios, both of which were set in the past year and a half resulted from extreme market conditions. Minimum ratios typically track closer to 50%, and the maximum closer to 150%. When the muni-to-Treasury ratio becomes low enough, investors may earn a higher after-tax yield by owning a Treasury position. They may also benefit from the reversion back toward the higher average ratio.

When the muni-to-Treasury ratio is low, an investor can sell out of relatively overvalued tax-exempt bonds and purchase a US Treasury or high-quality taxable municipal bond of the same maturity. When market conditions change and the ratio reverts to the mean, the investor can reverse the trade. These are often called crossover trades. When a professional active manager executes them properly, these trades have proven beneficial to certain investors.

An episode from December 2020 provides a useful example. A Treasury rally, heavy reinvestment flows, and lower new-issue supply created the perfect environment for ratios to drop below 60% in maturities of eight years or shorter. For example, the ratio of five-year AAA munis to five-year US Treasuries was 58% at the end of December 2020. This made it advantageous in certain instances to sell munis in favor of Treasuries. Ratios continued to get richer into the eight- to 10-year portion of the curve in January as reinvestment flows continued and new-issue supply remained muted. Across actively managed strategies where managers could implement this trade, investors purchased roughly $1.1 billion in US Treasuries, equating to roughly 15% of strategy composites. Yields have sold off significantly over the year to date, creating an opportunity to exit the Treasury trade and buy back muni bonds at cheaper valuations. While we’ve recently exited the trade in the 10-year part of the curve, we haven’t hit lower ratios to exit the Treasury positions in the five-year part of the curve.

The table below shows all the periods after 2008 when the muni-to-Treasury ratio has been rich. The beginning date is when the ratio of the five-year AAA muni bond yield to the five-year Treasury yield had been below 65% for a minimum of four consecutive trading days. The ending date shows when the ratio normalized to average levels, which we define as a period of four consecutive days when the ratio climbed above 80%. An investor able to cross over between these markets without transaction costs would have outperformed by 1.49% on average across the six crossover periods. Managers initiated the trade by rotating into Treasuries versus muni bonds of similar maturity and duration. 

Historical crossover periods

Historical crossover periods table

Source: Bloomberg, 3/21/2022. For illustrative purposes only. Not a recommendation to buy or sell any security.

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The trade-offs of crossing over

It’s important to consider the tax consequences of selling a municipal bond to buy a taxable position. Significant gains may erode the value of the crossover trade, when the realized gain on the municipal bond sold may outweigh any alpha that the trade may generate down the road. This is especially true in the case where municipal bond positions are trading at short-term gains.

We should also factor in credit ratings when comparing muni yields versus US Treasury yields. As investors move down the credit spectrum, the higher yield on bonds rated below AAA will typically result in cheaper ratios, which justifies staying in the muni asset class. Furthermore, the presence of embedded calls in municipal bonds with maturities longer than 10 years has limited this crossover to maturities shorter than 10 years.

The bottom line

Having a professional manager who can cross over between muni bonds and US Treasuries while minimizing friction costs may add better after-tax returns to an investor’s portfolio than a muni-only fixed income allocation. Between 2008 and the end of 2020, we’ve entered and exited the crossover trade across our actively managed accounts a total of six times, resulting in an average outperformance of munis versus Treasuries by roughly 153 basis points. High-tax individuals looking to take advantage of these types of inefficiencies would benefit from professional fixed income management. 

At Parametric, we strive to learn more about helping you help your clients. Part of that is constantly reassessing what we think we know. For Financial Literacy Month, we thought we’d give you the opportunity to do the same with this quick quiz.

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