Flow of Funds

Municipal Holdings Decline in 1st Quarter

The municipal bond universe got a little smaller this past quarter.

Holders of Municipal Debt

Numbers from the Federal Reserve’s flow of funds for the first quarter this year place total muni bond debt at $2.905 trillion. That compares to $2.925 trillion in the last quarter of 2010, according to Fed numbers, and $2.843 trillion over the same period last year.

Outstanding muni debt has declined in only three quarters since 2000: the third quarter of 2000, the second quarter of 2010, and now the first quarter of 2011. On top of that, the $20.5 billion decline in outstanding municipal debt this past quarter is the largest quarterly decline since the third quarter of 1995, when it fell $25.7 billion.

But the Fed’s numbers don’t add up for some in the industry. Analysts at Citi wrote in a recent market comment that the central bank has for years understated the size of the municipal bond universe, by around $795 ­billion.

The decline in outstanding muni debt in the first quarter isn’t a huge surprise, given that new-issue volume is off sharply and considering the ratio of reinvestment flows compared with new issuance, according to Alan Schankel, managing director at Janney Capital Markets. His firm projects reinvestment flows approaching $300 billion for 2011, with new issuance now projected to be only around $250 billion.

“The math leads me to believe that will happen,” Schankel said of the quarterly decline in muni debt. “Any measure would show it’s down, because the flows are larger than the new-issue volume.”

Foreign buyers showed one of the largest gains among bondholding sectors last quarter. Their investments jumped 3.2% to $75.2 billion in the first quarter in 2011 from a revised $73 billion in the fourth quarter of 2010. They have also seen an increase of 23.3% over a 12-month period. Much of this can be attributed to the success of the taxable Build America Bond program; dealers have noted over the past couple of years that foreign investors have an appetite for taxable municipal debt.

Commercial banks also saw gains of 2.5% this past quarter and 14.8% for the previous 12 months, Fed numbers show. Their muni holdings jumped to $251.8 billion in the first quarter 2011 from $246.1 billion in the fourth quarter of 2010.

Life insurance companies saw an increase of 1.7% for the quarter, but 41.1% growth over the previous 12 months. Specifically, the insurers held $115.1 billion of munis in the first quarter this year. That compares with $81.6 billion in the first quarter 2010, the Fed numbers show.

High muni-to-Treasuries ratios — yields for 30-year tax-exempt bonds exceed those for similar taxable Treasuries — could help explain the rise in institutional ownership, Schankel said.

“One possibility is that we’ve had a couple of points of inflection this year, where ratios got so high that crossover buyers came in,” he said. “Certainly, many life insurance companies qualify as crossover buyers; they don’t benefit from tax-free income. That would explain some of it.”

Households and mutual funds, the two largest groups of muni bondholders, both saw declines for the quarter. Household sector holdings fell from $1.084 trillion in the fourth quarter of 2010 to $1.078 trillion, or 37% of the total market.

Mutual funds, at 18% of the market, saw their holdings fall to $516.5 billion from $526.6 billion, quarter over quarter. This isn’t surprising news, given that municipal bond funds have seen 29 straight weeks of outflows, according to Lipper FMI. Muni bond funds, which saw solid inflows throughout the summer of 2010, held $501.5 billion 12 months ago.

But what is shocking, according to analysts at Citi, is how the Fed has for years understated the size of the muni bond universe by hundreds of billions of dollars. State and local debt outstanding should total $3.7 trillion, Citi estimated.

Behind the $795 billion discrepancy lie longstanding errors in the Federal Reserve’s methodology, particularly when it calculates households and foreign bondholders, Citi analysts wrote. Reporting organizations, such as the Investment Company Institute and organizations that oversee banks and insurance companies, provide the numbers the Fed uses to calculate major institutional sectors that invest in munis. Most everything else, including sectors from which the Fed doesn’t directly pull data from published sources, falls into the household sector and, to a lesser extent, foreign buyers of taxable munis, according to Citi.

“While the Fed takes a more flow-based approach to assess the size of the market, we estimate the size from the issuer’s perspective by aggregating the maturity face value of all bonds outstanding,” Citi analysts said in an e-mailed statement.

This discrepancy has accreted over time, they added.

For its number, Citi tracks every registered bond, analyst Vikram Rai said. Doing so gave the firm the outstanding notional value for all registered bonds. Citi then ran a series of database queries and aggregated the outstanding amounts.

“We believe the data [taken] from the issuers’ perspective,” Rai said. “It’s unlikely that they’ll overstate the amount.”

In response, the Fed issued a statement addressing Citi’s claims. “We are aware that some private-sector estimates of levels outstanding of municipal debt differ from the levels reported in the Federal Reserve’s Flow of Funds report,” the Fed wrote. “We are evaluating the discrepancy and working to resolve it.”


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