Nearly every talking head on financial TV points to the yield curve as currently being “inverted.” In other words, the short-term interest rate on US Treasury bills is higher than the interest rate on medium-term US Treasury notes. As this commentary is written, the one-year T-bill rate is about 4.5%, and the ten-year T-note rate is about 3.6%. Most commentators then say that this inversion of the yield curve suggests a forthcoming recession.
Does it? Maybe so or maybe no.
Let’s look at another yield curve and compare it with US Treasury debt. Because of the very recent pricing of a new issue, we are going to examine the yield curve of the market-based pricing of the general-obligation (GO) debt of the State of Alaska.
This analysis results from an internal discussion in the municipal bond management section of Cumberland. Hat tip to John Mousseau, Shaun Burgess, Amy Raymond, and Patty Healy for participating in the conversation. All errors are mine, if I missed a calculation.
At the very end of January, the State of Alaska sold a three-tranche issue of GO debt. This is the sovereign debt of the state and a very-high-investment-grade municipal bond issue (rated AA levels by Moody’s and S&P). The issue is federally tax-free to any US taxpayer. Note that comparable-maturity US Treasury obligations are fully taxable to that same taxpayer, so the “tax-equivalent yield” is very important in this discussion.
On final pricing, the 8/1/2023 maturity was priced at a yield to maturity of 2.6%. John Mousseau noted that this pricing resulted in a payment to the buyer that was below the taxable equivalent yield of the corresponding US Treasury T-bill. Thus, the buyer of this very-short-term tax-free GO debt would have been better off buying a taxable Treasury bill and paying the tax (assuming the top 37% bracket) than by buying the tax-free security.
The 8/1/2024 maturity had final sales pricing of a 2.42% yield to maturity. The 8/1/2025 tranche closed at a 2.34% YTM. So, you might say, “Look, the Alaska G.O. yield curve is inverted,” since the shortest note is priced with a higher interest rate than a longer note maturing next year or the year after that. You would be correct with that math. But if you made the same calculation against the corresponding Treasury securities and calculated the taxable equivalent yield, you would observe the opposite direction to the slope of the taxable equivalent yield curve. The reason is that the US Treasury yield declines significantly from its inversion peak while the tax free yield is essentially flat for a few years and then is rising.
We will discuss why in a moment.
We immediately wanted to see what we could find in the intermediate maturity of the Alaska GO yield curve. With Bloomberg’s help we found an Alaska State GO bond of ten years’ maturity with a call feature in 2030. So, we priced the Alaska intermediate bond on a yield-to-worst metric, and the yield was 2.58%. Remember, this is the same issuer, a state GO credit, and all the Alaska bonds mentioned herein are tax-free.
Let’s sum this up. The shortest issue was about 2.6% tax-free, and the intermediate-term issue was also about 2.6% tax-free. That yield curve is not inverted; it is flat.
We wondered if we could find a corroborating yield curve to support this observation. So, we searched — and, sure enough, there was one available.
We checked the pricing on the Alaska Muni Bond Bank issue. This issue is also tax-free, handled by Jefferies as the underwriter, and structured with similar maturities in a full scale of maturities from 12/01/2023 all the way out to 12/01/2052. That yield curve is only mildly inverted in the first few years (by about 5 or 10 basis points) and then upwardly sloping with a final yield of 3.89% in 2052. Note that in the later years the tax-free yield is higher than the taxable US Treasury yield of the same maturity.
Think about that, the tax-free Muni yield is higher than the taxable treasury yield. Normally that doesn’t make any sense unless you believe the entire income tax code is going to be repealed. We don’t expect that to happen.
So, there are no inversions of any consequence that we observed in the Alaska Muni Bond Bank series, and there is negligible inversion in the Alaska GO issues.
Okay, you may ask, why is there such a disparity between the yield curve of the tax-free debt of this sovereign American state and the US Treasury yield curve?
We think there is a reason for it. Actually, two reasons.
The first reason is that the pricing of the Alaska tax-free bond is set by wealthier Americans who are in higher tax brackets. It is their investment preferences that drive the prices in the $4 trillion tax-free municipal bond market of the United States. Those same folks rarely buy US Treasury obligations unless they are required to do so by some regulatory prescription. This is perfectly logical. Why pay taxes on a high-grade bond when you can achieve a higher after tax yield with a Muni?
Treasury obligations are priced by US institutions that must use them and by foreign buyers whose decisions are made by comparing sovereign high-grade debt yields around the world. Thus, the pricing is determined by two different sets of buyers with little in the way of overlapping preferences.
The second reason is that some of the US tax-free market pricing is driven by mutual funds. The funds experience an inflow, and the fund manager has no choice but to get the new cash invested at once. So, she or he has to go into the market regardless of how much or how little inventory is around and buy at whatever price it takes to get the position. By the way, the reverse is also true when mutual funds are experiencing outflows and managers are required to sell whether they want to or not.
Cumberland is a separate-account manager in the muni space. We don’t have to buy if we don’t like the pricing, and we don’t have to sell if the market is forcing the pricing that our bond management team has determined to be averse to the desires of our clients.
Here’s the result: We didn’t buy any of the new-issue Alaska GOs. We passed. Why should we buy a bond when we have better options for our clients?
In portfolio management, there are times when it is better to pass than to chase. The Alaska GO was one of those times in the opinion of the Cumberland bond portfolio management team.
One final note. Even if there is an inversion (which is certainly true in the US Treasury curve but not in the Alaska muni bond bank curve), that doesn’t guarantee a recession. In a recent tweet, Robin Brooks, a professional with good credentials, offered evidence in the form of a chart. You need Twitter to see the chart. Here’s his text:
“Yield curve inversion as predictor of recession has failed. 10-year Treasury yield (orange) fell below the federal funds rate (white) in 2019, much as it fell below the funds rate in 2022. In neither case did recession happen. Time to send the inversion signal into retirement...”
(https://twitter.com/RobinBrooksIIF/status/1621931359894749191?s=20&t=9owJumGLkvgl1s_U-zL4og)
There is disagreement on whether the inverted yield curve predicted the short recession felt from the effects of Covid in 2020.
That said, if we saw many of the yield curves inverted, including munis, we might react differently. That would imply that the Fed is so tight as to be choking the financial markets and the economy. That certainly doesn’t seem to be the case today.
David R. Kotok
Chairman & Chief Investment Officer
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