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Understanding Muni Bond Spreads

The municipal bond market has almost $4 trillion in total debt outstanding. That compares with about $18 trillion in outstanding U.S. Treasury debt. Besides market size, municipal bonds differ from Treasurys in that they carry credit risk, are less liquid and are exempt from federal income tax.

The size of the spread between Treasury bonds and municipal bonds is determined by the variation in one or more of those three differences. To investigate the municipal bond spread, the authors of a 2014 study—“The Muni Bond Spread: Credit, Liquidity, and Tax”—split it into its components.

They examined the credit component of the spread by comparing returns to municipal bonds that have been prerefunded and backed by Treasurys. Such bonds are considered to be riskless from a credit standpoint.

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