The Evolution of Treasury and Muni Bond Yields

As the Euro crisis has evolved it’s becoming increasingly popular to compare the EMU to the USA.  That is, the states in the USA are analogous to the countries in the EMU in that they are all users of a common currency and are not autonomous in that currency (ie, they can’t issue the currency independently).

And an interesting thing has happened during the financial crisis.  Europe’s nations have been roiled by economic weakness just like the US states have been.  The US state budget woes are well known and have even been the source of some Wall Street analyst’s dire predictions.  But no US state has even come close to experiencing a solvency crisis while several European countries teeter on the edge.  The most striking occurrence has been the surging bond yields across Europe.

I’ve discussed this in detail over the years and why the analysts crying for mass US state insolvencies were likely to be wrong, but now we have some interesting new analysis via VOX.  What’s depicted below is the 10 year US Treasury versus the 10 year muni bond index.  As you can see, the yields have an extremely high correlation – muni bonds practically ARE treasury bonds.  So why are yields surging in Italy, Spain, Greece and Portugal, but they’re remaining so tame in the muni market?  Simple – the US government, which can always procure funds via taxes and bond sales therefore making solvency a non-issue, provides substantial federal aid to the states every year.  While this doesn’t eliminate the solvency issue at the state level it certainly helps reduce it substantially.  Europe has no such mechanism in place so what you basically have is a bunch of US states in an environment where they’re left to fend for themselves.  They can’t print their own currency, they can’t devalue their own currency and they can certainly run out of Euros.  The result is bond investors who are terrified about default and end up selling bonds which only exacerbates the budgeting process.*

More below from the paper:

“The housing bust, the financial crisis, and the recession have devastated state and local tax revenues. As a result, the US municipal bond market has experienced worrisome signs of instability. The average rate on municipal bonds at times surpassed the rates on US Treasury securities. In normal times, rates on municipal securities are lower than on US government offerings because of the tax benefits municipals (munis) receive. The now higher borrowing costs for individual US states reflect concerns about their future revenues and pension obligations, among other things. In addition, there is no bankruptcy mechanism governing state defaults, unlike Chapter 9 for municipalities. In other words, US states can repudiate their debt. Under the 11th Amendment to the US Constitution, individual states have the same sovereign immunity as countries, and states can be sued only with their consent.”

* See below for more on why the institutional design of the US monetary system makes it unique compared to Europe:

JKH on the Contingent Insitutional Approach (advanced reading)

Understanding the Modern Monetary System

Monetary Realism’s recommended reading page.



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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • SS

    Interesting. I wonder what would happen if the federal government becomes serious about this balanced budget and how that might threaten state solvency?

  • Cullen Roche

    IF, for some reason, the implicit funding guarantee were eliminated, the states would be left floating in the wind….They’d be just like Euro nations with no govt or central bank to back them up.

  • Andrew P

    They would be serious about a balanced Federal budget only until the voters changed their minds and replaced the Congress/President. A bigger mistake would be to cede monetary sovereignty to a higher authority, such as the UN or IMF.

  • LRM

    Are you saying that states can refuse to pay their debts and that there is no legal recourse. In that case, why not have the state pick up the debt of these several cities that have declaired bankrupcy?
    The city has a state guarantee and the state has a federal guarantee and the federal guarantee is the printing press. All debt can be thus guaranteed from default and sold at very low interest or no interest. Throw in a couple of regulators and wait for the inflation that the FED wants to keep GDP Growing.

  • Tim

    Does that mean you think the weaker states are in better shape than they look? They’re certainly not in as dire straits as the PIIGS, but they’re not exactly doing well, either. California, for example, has massive budget deficits and long-term liabilities along with multiple recent municipal bankruptcies.

  • Bond Vigilante

    Do you really think that the Federal government would buy all the muni bonds ? It would comprimize its own balance sheet.

  • Cullen Roche

    They don’t need to buy. Muni bond investors know the federal govt wouldn’t let them go bankrupt (or at least the likelihood is incredibly low)….

  • Cullen Roche

    I don’t necessarily think thy’re “in better shape than they look”. I just see how much aid they get from the govt. It’s a lot like being in debt to a loan shark and having access to a secret ATM that you can only tap once every few quarters for so much funding. The loan shark knows you have access to this machine so he decides not to break your legs since he knows the likelihood of you being good on your payment eventually is high….

  • Cullen Roche

    The states have balanced budget amendments so they have to cut spending when revenue collapses. They have no choice. So it’s not about not paying the debt. It’s that they’ll reduce their budgets while getting huge aid from the feds. It helps avoid insolvency. Like having a credit card bill and having your parents slip you cash once every few months.

  • Bond Vigilante

    And that’s a point we’ll continue to disagree on.

  • Steve W

    Yes, the likelihood seems incredibly low, but I will always remember certain members of Congress encouraging Fannie & Freddie to raise more capital in early 2008. Investors snapped up the 8% fixed-rate capital securites(preferreds). I realize the issues didn’t have the same AAA rating as the GSE bonds (they were AA- as I recall). Then the government seized Fannie & Freddie, suspended dividends on the preferreds and continued to back the bonds. I realize this is somewhat apples to oranges, but it’s hard not to be pessimistic about what the government would do in a true muni bond crisis.

  • Johnny Evers

    The states have balanced budgets. Yes, the federal government helps them by recycling taxpayer money back to the states.
    So far as I know, no state is borrowing money to finance its spending, as do the U.S. and European countries.
    Municipal bond debt loads do not approach the level of federal debt loads, here or in Europe.
    Municipal bond loads are *not* backed by the full faith and credit of the U.S. government. Municipal bond issues do fail and I don’t believe the federal government ever bails them out.
    California cities are beginning to declare bankruptcy because they’ve run out of money.

    You’ve taken an idea — that government can never run out of money — and taken it to two extremes: 1. we can safely buy up munis because it’s understood that the federal government will step in to back them, and 2. the federal government *should* step in to buy munis. Again, the federal government can do whatever it wants, but there are consequences, of course.

  • Michael Mendelson

    The presumption of an implicit guarantee and the existence of fiscal transfers from the federal government are two different possible explanations for the low interest rates on US sub-national debt. A third possible explanation, at least in places like California, is the US state’s huge reservoir of potential tax revenue. Should California ever decide that it was in serious trouble and get the people to agree, it could resolve its deficit overnight by relatively small tax increases – at least relatively small compared to the rest of the world. All US states are lightly taxed compared to most of the developed world, even the most heavily taxed US states relative to other US states. I think the debt market presumes that faced with the prospect of bankruptcy and default, a US state would bite the bullet and raise taxes. Countries such as Spain and Ireland don’t have this option as their economies are floundering so badly, and countries like Italy and Greece do not have effective means of collecting taxes. I might mention, by the way, that Canada is in a similar position to the US, except more so in that our provinces have even more fiscal autonomy.

  • Cullen Roche

    You know, you shouldn’t just put words in people’s mouths.

    1. I never said anyone can buy up munis. In fact, I never tell anyone on this website to buy ANYTHING.
    2. I never said the govt “should” step in to buy munis.

    I said the states get substantial aid which reduces the risk of default. I know a lot of this is shocking to your prior ideological beliefs, but just because you don’t like the reality of it all doesn’t mean you get to come here and just put words in my mouth so you can stretch my words to make them appear as extreme as your own views. I’m just telling you how it is. I’d appreciate it if you not take a description and start stretching it out into false recommendations I’ve never made….

  • The Undergrad

    MBIA started off as a municipal bond insurer. And they made a killing off of it for they realized states would not let the municipalities go bankrupt just like the federal government would not let a state go bankrupt. The odds of a municipality going bankrupt are slightly lower than the odds we will see a QE induced hyper inflation at any point in the next decade.

  • Johnny Evers

    You’ve suggested — and then reiterate in one of your responses here — that the Federal government implicitly backs muni bonds.
    If that is the case, it all but guarantees that the Federal government will wind up buying munis. Something similar happened with Fannie Mae during the financial crisis. The muni market is almost $3 trillion — is it a good idea for the Federal government to back that up?
    You also make the mistake of assuming that because the states have become insolvent in the past five minutes that they will never become insolvent. The states have grave budgetary issues that may or may not be solved by printing money.

  • Cullen Roche


    The govt DOES implicitly back muni bonds. They provide billions in funding every year. You’ve taken a statement of fact of you’ve tried to misconstrue it to imply that I recommended munis as a risk free investment and that I somehow stated that the Federal govt has a responsibility or should do this. I stated neither of the claims you make. All I did was tell you why the states didn’t go bankrupt during the financial crisis and why they’re different than European nations. That’s totally different than what you’re suggesting I stated.


  • Bond Vigilante

    AFAIK, muni bonds are “Obama tax” exempt. So, another reason for investors to flock to muni bonds. Excellent investment, right ?

  • Edmund

    Not even Detroit?