This is not the immediate result that I expected. Standard & Poor's downgraded Treasury debt from AAA to AA+ on August 5. Yields on Treasury bonds have since come down across the yield curve. For example, the ten year Treasury closed today at a yield of 2.22% (all quoted from Bloomberg) after touching 2.03% briefly last week. Of course, the reasoning has more to do with the weak economic performance than the ratings, but it is still unexpected.
The municipal market continues to be relatively attractive. The tax free yield curve is right on top of the Treasury curve, with a benchmark ten year AAA bond yielding 2.295%. Same credit quality, same maturity, same yield, plus the interest is tax exempt. Buying tax exempts is a taxable account is a no brainer. It is even worth considering buying munis in a tax deferred or tax exempt account Consider it another dimension of diversification.
With the downgrade, we must also consider the question of the risk free benchmark. An argument could be made for the short Swiss sovereign or LIBOR. Both represent stable high quality credits, are transparent, and are investable. Each can also be be fairly easily and cheaply hedged to the dollar. However, the market has indicated that Treasuries are still considered of the highest quality. Therefore, I am inclined to continue to use T-bills as the risk-free proxy.
We live in interesting times, but that does not make decision making any easier. At the moment, it appears that the markets are valuing Treasuries as if they are risk-free. Municipals, on the other hand, are being priced with a yield premium of 28%. Looks like an arbitrage opportunity to me.
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