Buy Side

Muni Sales Show Serious 2Q Surge

Retail investors and mutual funds snapped up municipal bonds in the second quarter, powering the fastest growth in outstanding state and local government debt in two years.

Municipal debt outstanding jumped to $2.779 trillion during the second quarter, according to the Federal Reserve, marking 4.2% growth over a 12-month period in which many credit markets were frozen and the economy suffered the worst recession since the Great Depression.

The market grew by $61.6 billion during the quarter, reflecting tireless buying by retail investors and mutual funds and tireless selling by money market funds.

Households added $42.3 billion to their municipal bond stockpile in the second quarter, which is the third-heaviest period of buying since 1945.

Households - on pace for their most acquisitive year ever - own $996.8 billion in munis, or 36% of bonds outstanding.

Matt Fabian, managing director at Municipal Market Advisors, in a report yesterday wrote retail investors' ravenous consumption of munis speaks to the "de-institutionalization" of demand for local government debt.

To illustrate: the municipal market has grown by $112.8 billion in the past year. In that span, households have acquired $102.3 billion in munis.

In his weekly report last week, George Friedlander, muni strategist at Morgan Stanley Smith Barney, put households' buying into perspective: households' purchases of municipals in the first half this year is more than double their average annual purchases since 1996.

"Clearly, the 2009 appetite for munis from individuals has surpassed any prior period in the history of the market, by a wide amount," Friedlander said.

Also obliterating precedents were mutual funds, which, bolstered by relentless fund inflows from investors, boosted their holdings by $23.5 billion. This was by far the most mutual funds have ever bought in a quarter.

According to the Investment Company Institute, municipal bond mutual funds commanded almost $17 billion in inflows during the second quarter.

Mutual funds own $430.3 billion of munis, or 15.5% of outstanding municipal debt.

Some institutional investors also stepped up their buying, Fed data shows.

Property-casualty insurers accumulated $10.7 billion of munis, notching their most acquisitive quarter since 2005. They now own $395.3 billion, or 14.2% of the sector. A return to profitability likely fueled insurers' buying.

Profitable insurance companies usually buy municipal bonds for the tax-exempt coupon payments, to cocoon income from taxes. An insurer that is not booking a profit does not pay taxes and has no reason to invest in tax-exempt securities.

According to the Property Casualty Insurers Association of America, the industry lost $11.6 billion in the second half of 2008, and an additional $1.3 billion in the first quarter of 2009.

Though the PCIAA has not yet reported the industry's results for the second quarter, the story was likely different as many of the biggest insurers turned a profit.

Allstate Corp., for example, earned $389 million in the second quarter, while Travelers Cos. earned $740 million.

Even American International Group Inc., which lost almost $100 billion in 2008, returned to profitability in the second quarter for the first time in seven quarters.

Commercial banks added $5 billion of munis in the period, likely prodded by tax regulations under the stimulus bill.

The American Recovery and Reinvestment Act lifted the ceiling on how little an issuer has to borrow in a single year to be qualified for tax-favored holdings by banks, to $30 million from $10 million.

The stimulus also allows commercial banks to deduct 80% of the cost of buying and carrying tax-exempt bonds as long as their tax-exempt holdings do not exceed 2% of their assets. That rule - known as the 2% de minimis rule - previously only applied to nonfinancial corporations.

One interesting dynamic in the quarter was a marked increase in buying from the "rest of the world" category, which measures foreigners' purchases in U.S. markets.

Foreigners bought $5.6 billion of municipals during the second quarter, which Bank of America-Merrill Lynch muni strategist Phil Fischer said was probably attributable to the Build America Bonds program.

Also created under the stimulus legislation, BABs are taxable munis under which the Treasury pays the issuer a cash subsidy equal to 35% of the bond's interest costs, in lieu of the tax exemption.

Foreign investors are among the many classes of investors BABs are designed to appeal to. Issuers sold $15.6 billion of BABs during the second quarter.

Fischer said he expects foreigners to buy more munis in future quarters as the BAB program gains further traction before it is due to expire at the end of 2010.

Rampant buying among mutual funds, retail investors, commercial banks, property and casualty insurers, and foreign investors more than offset the jettisoning of municipal paper by money market funds.

Money market funds are bedeviled by sickly yields on the types of products they typically buy, coupled with a severe shortage of those products.

As a result, money market funds are offering negligible returns to investors. According to iMoneyNet, the average tax-free money market fund offers a yield of 0.05%, which is the lowest rate ever.

Whether it is because investors are tired of earning nothing on their money or have acquired a heartier appetite for risk, cash is fleeing money market funds at a remarkable pace.

Since achieving peak assets in August 2008, tax-free money market funds have shed $93 billion, including a staggering $7.5 billion outflow last week, according to ICI.

Tax-free money funds have been selling their paper to meet redemptions. The sector dumped $26.9 billion of munis during the second quarter.

Fischer said the Fed data offer an instructive counterweight to the prevailing wisdom in the muni market.

Most people are focused on the shortage of tax-exempt paper as a result of the BAB program and a lack of market access for lower-rated issuers that in the past years relied on bond insurance.

Fischer said this focus is misguided: the supposed shortage is in variable-rate debt, which money market funds are selling anyway because investors are ferrying their money out.

Through August, sales of variable-rate debt were down 78.2% from last year, to $18.1 billion from $82.8 billion, according to Thomson Reuters.

Fixed-rate issuance was up 9%, to $193.7 billion from $177.7 billion.

"Even allowing for the influence of BABs, there's more paper now than there was before," Fischer said.

In case anyone is wondering why debt outstanding is up while issuance is down, Fabian explains: the rate at which issuers have been refinancing bonds has slowed more than the rate of new issuance. Thus, more debt is being left outstanding rather than being defeased, leading to growth in spite of less issuance.


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