An atrocious three months for stocks chased retail investors to the safer perches of government bonds in the first quarter of the year, enabling state and local governments to continue borrowing.
Municipal debt outstanding grew 1.3% in the first quarter to $2.716 trillion, according to Federal Reserve data released Thursday.
That represented a 2.7% growth rate from the end of the first quarter last year.
A 2.7% annual growth rate is decidedly slower than most of the industry's history.
The amount of municipal debt outstanding has grown at a compound annual rate of a little better than 8% since the early 1950s, according to Fed data.
That encompasses a 7.3% annual rate in the 1960s, a 10.7% rate in the 1970s, a 12.2% rate in the 1980s, and a 2.4% rate in the 1990s.
This decade, the market grew at an 8.5% rate until 2007. The recession that began in December 2007 and the implosion of the bond insurance industry in 2008 kept the growth rate in 2008 to 2.4%, the sixth-slowest rate of growth since the Fed began tracking the data in the early 1950s.
Nevertheless, municipal debt outstanding in the first three months of the year grew at the fastest pace in five quarters in the face of widespread evaporation of wealth and a drubbing in financial markets.
After bleeding $10.885 trillion in wealth in 2008, the household sector coughed up another $1.33 trillion in the first quarter, Fed data showed. The culprit was plummeting market values for real estate and stocks. The Standard & Poor's 500 Index tumbled almost 12% in the first quarter.
Investors responded by ferrying money out of stocks and squirreling it away into the relative safety of bonds.
Households bulked up holdings of municipal bonds by $18.6 billion, lifting ownership to $968.5 billion, an increase of 7.5% from the end of the first quarter of 2008.
The household sector, which under the Fed data system includes hedge funds, more than doubled holdings of Treasury bonds and beefed up holdings of corporate and foreign bonds by 27%.
Households' holdings of stocks, meanwhile, dipped 5.8%.
Households directly owned almost 36% of outstanding munis at the end of the first quarter. The average proportion since 1952 is 39%.
"Individuals were big buyers in the first quarter," said Evan Rourke, a portfolio manager at Eaton Vance.
Another source of growth associated with retail buyers was mutual funds, which, driven by cash inflows from investors, snapped up $16.5 billion in munis.
Mutual funds' $406.1 billion in holdings at the end of the quarter represented 15% of outstanding munis.
It is not clear what percentage of muni funds are owned by households. Overall, households own 64% of mutual funds, according to the Fed.
According to AMG Data Services, investors poured about $11.5 billion into muni funds during the quarter. Funds reported an additional $13.2 billion in market appreciation.
Flows into muni funds spiked to an unparalleled pace this quarter and are on track to smash the record for inflows in a year.
In his weekly report, Bank of America-Merrill Lynch municipal strategist Phil Fischer said it is not surprising households are adding munis to their portfolios, while commercial banks are selling and property and casualty insurers are increasing holdings marginally.
Property and casualty insurers' muni holdings grew 0.6% to $375 billion in the first quarter, while commercial banks shed 0.9% of their holdings, to $213.8 billion. Slow growth in insurers' holdings makes sense at a time when they do not have much income to shelter from taxes.
Commercial banks, besieged by liquidity constraints, cannot afford to hold on to investments with credit or liquidity risk. Commercial banks also dumped $21.6 billion in corporate and foreign bonds and almost $3 billion in stocks in the quarter, according to the Fed data.
Heavier holdings at households and mutual funds helped offset the exodus of cash from tax-exempt money-market funds, which are the second-biggest holders of municipal debt.
Money-market funds dumped $11.9 billion in munis during the first quarter. The sector held $482.7 billion in munis at the end of March.
Peter Coffin, founder of Breckenridge Capital Advisors, said he is surprised muni money market funds did not shrink even more.
Money market funds invest in super-safe, short-term investments and offer clients low returns and ironclad safety.
Money market funds have to compete for client dollars with bank accounts, which offered unusually low interest rates during the first quarter.
Plus, in the tax-exempt space, some of the traditional products money market funds invest in - such as variable-rate debt notes - became ineligible for purchase because of downgrades.
Coffin said that forced a lot of dollars out of money market funds and a lot of supply out of the short-term market and into the traditional long-term bond market.
"The VRDN market used to absorb a lot of supply that would have otherwise gone into the long end of the market," Coffin said.
Retail investors' embrace of munis helped state and local governments continue to borrow amid turmoil in the credit markets, swelling liabilities, and shrinking tax receipts.
Local governments' collections of personal income taxes shrank 8.2% in the first quarter to $297.8 billion, according to the Fed.
Meanwhile, local governments' liabilities excluding employee retirement funds mushroomed at an annualized rate of $147.6 billion during the first quarter, the steepest incline in liabilities since 2007.
