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Data Show Changes in Muni Buying Patterns

While individual investors — the primary owners of municipal debt — have generally increased their holdings in the last 10 years, some institutional investors have trimmed their holdings and others have been aggressive buyers.

Holders of Municipal Debt

In the wake of the financial crisis, property and casualty insurers and government-sponsored enterprises became sellers while foreign investors and life insurance companies flocked to taxable munis. Banks in general have ramped up their holdings.

The shifts in sentiment are reflected in data from The Bond Buyer/Thomson Reuters 2012 Yearbook, published this week.

The data, drawn from the Federal Reserve Board, show that there have been shifts in the top five municipal debt holders since 2001. Money market funds have slipped from number two in 2001 to fourth place in 2011. Households, which include individual investors, remain the number one holder of munis.

Mutual funds, a proxy for individual investors, have risen from being the third biggest muni debt holder in 2001 to being the second biggest in 2011.

During the same period, property and casualty insurers have risen from being the fourth largest to being the third largest, even though they have reduced the total amount they own in the last three years.

The Federal Reserve data indicates that the total municipal debt outstanding went from $1.60 trillion in 2001 to $3.74 trillion in 2011, a 133.4% increase. All debt totals are for Dec. 31 of the year mentioned.

In December the Fed revised all of its outstanding municipal debt data going back to 2004. The new method revised the central bank’s estimate of the amount of municipal bonds held by households by an average of $840 billion per year since 2004. This increase in household muni portfolios also increased the number for total debt outstanding.

The Fed did not use the new methods to revise estimates for muni debt outstanding for years before 2004.

There was a great deal of leveraging that went on in the past decade, including in the public sector, according to Peter Hayes, head of the municipal bonds group at BlackRock. That helps to explain why total muni debt expanded as much as it did, he said. 

This story’s figures are not adjusted for inflation. Inflation from 2001 to 2011 was about 27%.

Using the official Fed figures for household ownership of municipal debt, it went from $581 billion in 2001 to $1.9 trillion in 2011, a 224% increase. However, the Fed acknowledges that the data before 2004 is inaccurate. If one assumes that the actual household holding was $1.401 trillion in 2001, then the actual increase was about 34%.

Households, attracted by tax-exempt interest, increased their muni holdings because wealth levels have increased generally since 2001, Hayes said. “With aging baby boomers more concerned with income than return, munis became the investment of choice,” he said.

Most of the jump in household holding was due to the Fed’s methodology change, said Alan Schankel, managing director of fixed-income research at Janney Montgomery Scott LLC.

The amount of municipal debt held by mutual funds went from $253 billion in 2001 to $543 billion in 2011, a 115% increase.

The low interest rates of the last decade have encouraged investors to turn to mutual funds, according to Richard Ciccarone, chief municipal strategist at McDonnell Investment Management LLC. Investors have found they can get higher rates by investing in mutual funds than by investing in individual bonds, he said.

In this period investors have found mutual funds to be convenient, Ciccarone said.

Due to fears of default, many retail investors withdrew cash from mutual funds in 2010 and 2011, noted George Friedlander, senior municipal strategist at Citi. Mutual funds are now slowly growing again.

While property and casualty insurers held $174 billion in municipal debt in 2001, they held $347 billion of this debt in 2011, a 100% increase.

The insurance industry sees munis as safe assets, said Steven Weisbart, chief economist at the Insurance Information Institute. Property and casualty insurers have traditionally held more munis than life and health care insurers because of tax reasons, he noted.

The P&C insurers took a hit to their profits when the housing bubble burst in 2008, Friedlander said, and they have been reducing their holdings of municipal debt since then. He said because they are still suffering, they will be slow purchasers of muni debt in the next few years.

The fourth ranked holder of municipal debt, money market funds, held $296 billion in 2011 compared to $277 billion in 2001, a 7% increase. Adjusted for inflation, money market funds actually held about 20% less muni debt at the end of the period than at the beginning.

Muni money funds holdings peaked in 2008 at $495 billion. Even without considering inflation, there was a 40% decline from 2008 to 2011.

Issuers are not creating the product, variable-rate demand notes, that the funds use, Friedlander said, which is why money market funds have fewer munis. As VRDN use continues to diminish, money market funds’ holding of munis will also shrink.

The Federal Reserve’s policy of very low interest rates has caused money market funds to lose money, said Robert Nelson, managing analyst at Municipal Market Data.

In contrast to money market funds, the fifth biggest holder, commercial banks, held 139% more municipal debt in 2011 than in 2001. While total growth has been impressive, some of the years (2002 and 2009) saw very little growth.

Analysts said three factors have led to a recent growth spurt. Banks are increasing the amount of direct lending to municipalities in recent years, according to Ciccarone.

Provisions in the American Recovery and Reinvestment Act of 2009 made it easier for banks to hold munis, said Hayes and BMO Capital Markets managing director Justin Hoogendoorn.

Big banks with large retail bases find the costs of deposits low, so they can make money investing the retail money in munis, Friedlander said.

The sixth largest holder of municipal debt, life insurance companies, trailed far behind commercial banks but had explosive growth in the decade under review. In 2011 they held $118.9 billion, up 536% from 2001.

Life insurance companies started from a very low level, Hoogendoorn noted. Since they have long-term exposures it’s natural for them to purchase munis with long-term maturities, he added.

Life insurance companies purchased a lot of Build America Bonds in 2009 and 2010, boosting their total holding of municipal debt, Friedlander said.

The seventh largest holder of municipal debt, foreign holders, also experienced explosive growth since 2001. They went from just $8 billion in 2001 to $83 billion in 2011, a 934% increase.

“As municipalities started to issue more taxable bonds, this started to attract additional investors,” Schankel said.

The issuance of BABs accelerated foreigners’ holding of munis, according to analysts.

In the financial crisis foreigners saw investing in U.S.-based bonds as a safe haven, Hoogendoorn said. Sometimes they could get a better yield from a triple-A rated state like Maryland than from the U.S. Treasury, he said.

The 10th ranked holder of municipal debt, government-sponsored enterprises, experienced a 40% decline in their muni holdings from 2001 to 2011. While they started with $35.4 billion in 2001, they ended with $21.4 billion in 2011.

Among the GSEs are Freddie Mac and Fannie Mae, which have had financial difficulties in recent years. They have been using more and more of their assets for mortgage lending.

The 12th biggest holder of muni debt held essentially none of this debt in 2001. Only in 2007  did exchange-traded funds appear in the numbers. As of 2011 the funds held $8.6 billion.

With the financial crisis it became harder to do credit research, Hayes said, and in response, individual investors turned to mutual funds and ETFs. ETF's higher transparency and liquidity are pluses for attracting investment, he said.

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