MOB spread or municipals-over-bonds spread is the yield spread between a municipal bond and a Treasury bond for the same maturity.
How it works
When municipal bond contracts fall slower (or rise faster) than Treasury contracts, the MOB spread will widen. Conversely, when the Treasury contract outperforms the municipal bond contract, the spread will narrow.
To gain profits from increased MOB spreads, a trader takes a short position in a Treasury contract and a long position in a municipal bond contract. Even though both contracts go up in price, as long as the Treasury contract underperforms the municipal bond contract, the trader makes a profit.
Conversely, to profit from a falling MOB spread, traders will take long positions in Treasury contracts and short positions in municipal bond contracts.
Determinants of MOB spread
The spread is mainly influenced by interest rates. When interest rates fall, the spread will go down. Treasury bonds do not have call options, while municipal bonds do. So, when interest rates fall, bonds that don’t have call options will outperform bonds that have call options.
Lower interest rates allow issuers to call bonds at any time and can reissue bonds with cheaper interest. Thus, the risk for bondholders increases with decreasing interest rates. Therefore, a decrease in interest rates will cause the spread to fall.
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Changes in the constituents of the municipal bond index also affect the spread. The index is usually reconfigured to enter newly issued munis and bring out older bonds. And in this case, the constituent components of the index determines how the index will respond to changes in interest rates.