Buy Side

Muni Holdings Beef Up

MAR 11, 2010 6:20pm ET
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State and local governments  amassed their biggest-ever debt burden during the fourth quarter, meeting demand from retail buyers and a broadened investor base driven by federal stimulus programs.

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According to Federal Reserve data released Thursday, municipal bonds outstanding swelled 1.4% in the fourth quarter to $2.812 trillion from $2.773 ­trillion.

The muni bond market grew 4.5% last year and its size has nearly doubled in the past decade. Last quarter’s rate of growth was the most rapid since the fourth quarter of 2007.

Most municipal financing in the fourth quarter was delivered by the investors most accustomed to lending to states and localities: retail.

Households, the familiar standby for municipal borrowers, stockpiled $26.4 billion of municipal bonds to bring their total to $997.8 billion.

Other vehicles traditionally associated with retail also beefed up their holdings, particularly mutual funds.

Mutual funds’ ownership of municipal bonds catapulted $20.7 billion, to $479.7 billion.

Retail investors have gorged municipal bond mutual funds with cash for more than a year. According to the Investment Company Institute, investors bestowed $14.4 billion to municipal mutual funds in the fourth quarter and more than $69 billion for the year in 2009.

Mutual funds now own 17.1% of outstanding municipal bonds, their highest share since 1999.

James Colby, municipal strategist at Van Eck Global, said much of the money hitting mutual funds was likely coming out of money market funds, the safe-haven asset class that has been bleeding money for more than a year.

Money-market fund yields are minuscule right now because of the Fed’s campaign to keep short-term interest rates tethered to zero, as well as a precipitous decline in the issuance of the types of products money funds buy, such as variable-rate debt obligations.

The average yield on a tax-free money market fund is a record-low of 0.02%, according to iMoneyNet.

Rather than continue to stomach such paltry returns, Colby said, investors likely headed for higher-yielding products like mutual funds.

“With the impossibly low rates that municipal money funds were able to deliver, rather than, at a cost, keep money in a money fund, [investors] were moving out a little on the curve just to earn some income,” Colby said. “Mutual funds I’m certain were the beneficiaries of a lot of that move.”

Money funds’ dispositions and mutual funds’ acquisitions of municipals last year were nearly symmetrical, according to the Fed.

Money funds dumped $90.1 billion in municipal debt in 2009, while mutual funds accumulated $93.3 billion.

The biggest buyers of municipal bonds other than retail are property and casualty insurers, which accumulated $7.8 billion in the fourth quarter to bring their hoard to $412.6 billion.

Property and casualty insurance ownership typically fluctuates with profitability. Insurers that are losing money cannot benefit from the tax exemption on municipal debt because they do not have taxable income anyway. On the other hand, profitable insurers have taxable income to shelter by storing it in tax-exempt bonds.

Many major insurers were profitable in the fourth quarter, with the glaring exception of American International Group. AIG lost more than $12 billion last year after losing nearly $100 billion in 2008.

AIG is the third-biggest institutional owner of municipal bonds, according to Lipper, after the mutual fund families Vanguard Group and Franklin ­Templeton.

Virtually all of AIG’s $54.5 billion muni bond portfolio is still for sale. The company’s portfolio shrank by nearly $7 billion last year, according to the company’s financial statements.

Another major property insurer, Allstate Corp., also shed municipals from its $21.3 billion portfolio.

The Northbrook, Ill.-based insurer, which is the ninth-biggest institutional holder of municipals, sold $1.88 billion in munis last year.

Thomas J. Wilson, chief executive officer, said in a conference call with investors last month that the company decided to sell into the market strength last year because municipalities’ revenue declines and balance sheets “don’t look pretty.”

Commercial banks, which until the 1970s were the predominant buyers of municipals, held steady in the fourth quarter with $217.7 billion in muni ownership, or 7.7% of the total market.

While traditional buyers may have contributed the most to the expansion of the public finance market in the fourth quarter, the complexion of municipal bond ownership is anything but traditional.

If one defines “retail” as households, mutual funds, money market funds, and closed-end funds, retail investors own 69.7% of outstanding municipal debt, unchanged for the quarter and very much in accordance with historical norms.

The remaining 30.3% is changing dramatically.

Municipalities are floating bonds to investors that until recently held little if any state and local government debt.

Most notably, foreign investors now own $60.6 billion in municipal debt, a $7.1 billion increase for the quarter and $19.6 billion leap for the year.

This is likely attributable to the Build America Bonds program established through the American Recovery and Reinvestment Act last year.

The program authorizes state and local governments to forego the customary tax exemption on their debt and instead float taxable bonds and receive a federal subsidy. By issuing taxable debt, municipalities are reaching investors who normally have no reason to dabble in tax-exempt bonds, including pension funds, endowments, and foreign investors.

Municipalities sold about $64 billion in BABs last year, according to Thomson Reuters, or roughly 15% of the more than $400 billion municipalities issued.

Already this year municipalities have sold $15.8 billion in BABs. Through the first two months of the year, 24.6% of new municipal bonds issued in 2010 were BABs.

Richard Ciccarone, head of municipal research at McDonnell Investment Management, said it was just as interesting where BABs did not show up as where they did.

For example, he expected public pension funds to snap up some BABs, but the sector showed no new ownership of municipal bonds.

Also, life insurers, supposedly big buyers of BABs, added just $800 million in municipals to their roughly $50 billion in holdings during the quarter, hardly indicative of voracious demand.

Another fairly new type of investor snapping up municipal debt is the exchange-traded fund.

Non existent until 2007, ETFs bought $3.6 billion in municipal bonds in 2009 to bring their total to $5.9 billion.

The amount of money municipalities are borrowing does not mean they are spending more. Quite the contrary: the numbers from the Bureau of Economic Analysis show state and local government spending has hardly budged the past two years.

Why are municipalities borrowing more when they are not spending more?

George Friedlander, municipal strategist at Morgan Stanley Smith Barney, said many states are borrowing money to finance projects they used to finance with tax revenue.

Squeezed by weaker spending patterns and shrunken incomes, state and local government tax receipts have been more or less flat since the end of 2006, based on the seasonally adjusted annual numbers provided by the BEA.

Reluctant to raise taxes in a recession, municipalities have opted to borrow money in the bond market to pay for projects, Friedlander said.

He said this typically works in cycles. When times are good, municipalities can slow their borrowing because tax receipts are covering a greater proportion of ­expenses.

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