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Muni Market Witnessing the Changing Face of Ownership

The municipal bond industry might be catching an early glimpse into what the “new normal” will look like.

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Time was, ownership of municipal bonds was mainly the province of rich people in high tax brackets, with some profitable banks and insurance companies looking to shelter earnings from taxes sprinkled in.

Times are changing fast.

A Federal Reserve report released yesterday showed foreign investors snapping up a hearty share of new municipal bonds.

Further, investment vehicles such as exchange-traded funds are encroaching on what was once a market dominated by households.

In the third quarter overall, the face value of municipalities’ outstanding bonds grew 0.77% to $2.77 trillion. Outstanding muni bonds have expanded 3.7% in the last year and have doubled since the third quarter of 1998.

While the amount of municipal debt continues to grow at a steady pace, the composition of who owns them is transforming.

By far the most significant morphing of the municipal bond buyer this year was the passage in February of the American Recovery and Reinvestment Act.

That legislation created the Build America Bonds program, which enabled municipalities to forego the traditional tax exemption on their debt and instead issue taxable debt and receive a federal subsidy equal to 35% of the interest costs.

BABs enable municipalities to float debt that is more attractive to new types of investors who already are tax-advantaged and therefore have no reason to bid for tax-exempt bonds.

Many issuers have found it is cheaper to borrow money in the taxable market with the federal subsidy than in the tax-exempt market without it.

The result has been a $60 billion eruption of BAB sales into the taxable market in the last eight months.

Of the roughly $300 billion in municipal bonds sold since BABs first entered the market in April, nearly a fifth have been Build America Bonds, according to Thomson Reuters.

The Fed report, which shows who owns what, reflects this shift.

Foreign investors — one of the primary target audiences for the BAB program — owned $53.5 billion of municipal bonds at the end of the third quarter, a leap of more than a third since the BAB program launched.

According to the Fed, foreign investors bought municipal bonds at an annual clip of $31.7 billion in the third quarter.

“This should help put to rest the question about whether or not BABs are being purchased by international institutions,” said Phil Fischer, head of municipal strategy at Bank of America Merrill Lynch. “They obviously are doing so at an accelerating rate. ... The initial holders of BABs were primarily domestic, but over time we would expect that most of the BAB issuance would migrate to foreign institutions.”

Another illustration of the shifting winds in public finance was a new line item in the Fed’s municipal securities table: exchange-traded funds.

No ETF devoted to municipal bonds existed in mid-2007. Now there are more than 20, and they have snapped up $5.1 billion in municipals, according to the Fed. Their assets have nearly tripled in the last year.

This is not to say the retail investor has vanished from the municipal market. Far from it: households remain the single largest category of muni bond holders. They owned $979.5 billion in municipals at the end of the third quarter, the most households have ever owned.

The market share of investment classes associated with retail investors — households, money market funds, mutual funds, and closed-end funds — remains at 70%, where it has been for 20 years, give or take a few percentage points.

The categories showing lower market share than a year ago are broker-dealers, government-sponsored enterprises, and commercial banks.

The Fed’s report also reflected the migration of cash out of money market funds and into mutual funds.

Municipal bond mutual funds and tax-free money funds combined own $880.6 billion of municipals, or about a third of the market.

Tax-free money funds all year have been coughing up cash and municipal mutual funds have been attracting it.

As of the end of September, investors had ferried $73.6 billion out of their tax-free money funds and entrusted $54.7 billion to muni mutual funds, according to the Investment Company Institute.

In the third quarter, tax-free money funds’ municipal holdings shrank 7.7% to $420.6 billion, while mutual funds’ municipal holdings swelled 6.8% to $460 billion.

These numbers show that money is not leaving the municipal market, Fischer said. It is merely extending to longer maturities in search of better yields.

Money market funds invest in super-short-term, super-safe paper to provide investors with the equivalent of cash.

The Fed’s campaign to keep short-term interest rates latched to zero has pulled down the yields on most of the products eligible to be purchased by money market funds.

Tax-free money funds yield just 0.03%, according to iMoneyNet — a record low.

Impatience with such low yields has coaxed money off the sidelines and into mutual funds, where it can generate a better return, Fischer said.

“The numbers [showing mutual fund inflows and money market outflows] are almost a match, which suggests that there’s not a lot of leakage out of the muni market per se,” Fischer said. “People are staying with municipal bonds, simply seeking higher yields with duration extensions.”

The combined market share of mutual funds and money market funds has barely budged in the last two years.

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