Retail Demand Thrives Amid Debate over Direct Ownership or Mutual Funds

Retail investors, the biggest owners of municipal debt, are choosing funds over direct investments more often these days after interest rates dipped in this year's rally.

"The recent stock market correction and volatility only reinforces the interest in holding municipal bonds -- in one form or another," said Richard Ciccarone, president and chief executive officer of Merritt Research Services LLC.

Households still lead the industry in terms of ownership of municipals, though Federal Reserve data indicates a 1% decline in the sector's ownership of municipal bonds in the midst of 2.5% growth in mutual funds this year, Ciccarone said.

"Municipal bond funds have a propensity to experience inflows whenever interest rates decline," Ciccarone said. "As bond prices go up, NAVs go up and total return performance follows. That's just what happened when interest rates took a dip downward as global unease caused some investors to take refuge in bonds."

He added, "despite the recent slippage of household holdings of munis they still represent nearly four times the overall size of municipal mutual funds."

Households trimmed their holdings to $1.602 trillion in the second quarter from $1.609 trillion in the previous quarter and $1.665 trillion in the second quarter of 2013, according to Federal Reserve quarterly data released in late September.

It was the 14th quarter straight that ownership of municipals by U.S. households declined and brought the total to its smallest amount since the first quarter of 2006, according to the Fed data.

"Direct purchase of municipal bonds has not been as robust as mutual funds lately," Ciccarone said, pointing to relatively low absolute yields as the barrier for individuals with buy and hold accounts.

Inflows for all municipal bond funds fell for their third straight time in Lipper FMI's most recent report to $37 million from $41 million.Yet, overall, retail's appetite is still hearty, experts said.

"The household sector category also incorporates separate-managed accounts for individuals, which have been growing in recent years," Ciccarone said. "That investor sub-class provides the benefit of professional management and credit selection without the mutual fund redemption challenge when interest rates go up."

Alan Schankel, managing director at Janney Montgomery Scott, said households are still the largest segment of municipal bond holders, owning 44% of outstanding bonds - compared to 27% held by mutual funds.

The household share is down from 50% in 2009, while the mutual fund share is about the same, according to Schankel, who said an increase in bank holdings offset any slack.

"A reduction in household share since 2009 probably reflects the impact of the 2008 financial crisis, and specifically the demise of AAA bond insurers, which were a mainstay for retail investors," Schankel said. "Given the highest federal income tax rates since the Reagan years, and receding credit concerns, I would expect the household share to stabilize in coming quarters and years."

Individual bonds still make more sense for larger clients, and the embedded yields in the mutual funds make them more attractive relative to individual bonds for smaller investors, said John Mousseau, managing director at Cumberland Advisors in Vineland, N.J.

"The problem with funds is that investors are subject to only one price -- that of the fund - where individual bonds in different maturities offer more options," Mousseau said.

In the ongoing debate over holding individual bonds or owning mutual funds, John Donaldson, director of fixed income at The Haverford Trust Co., said mutual funds offer the attraction of daily liquidity, portfolio diversification, greater duration, and higher yields to offset any credit risks and price volatility, yet investors can better control more risk by owning individual bonds.

He said individual bonds allow financial advisors to structure a portfolio to clients' tolerances for credit risk, duration, and tax efficiency.

"Clients' motivation to own bonds includes generating income, preserving principal, and dampening the volatility of other asset classes," Donaldson said. "Individual bonds satisfy the preservation of principal and lower volatility criteria," Donaldson added.

Dan Heckman, senior fixed income strategist in the wealth management division of U.S. Bank, said municipal holdings are on the rise - through both municipal bond fund ownership and direct purchase.

"We have seen cash inflows week in and week out into bond funds, which points to rising demand for muni bonds," Heckman said.

"We are seeing a lot of interest in munis," he said. "They performed well and rebounded to be one of the single best fixed-income sectors this year -- after tanking last year."

Donaldson said recent market volatility has heightened the importance of liquidity and trading costs, particularly for any sales.

"We are placing an increasing emphasis on liquidity as we consider the costs of any tactical moves in client portfolios, particularly the prospect of rebalancing asset allocations back to target levels if there is a sufficient correction in equity markets," he said.

"As a result, we are more open to the use of funds as a solution for clients than we have ever been," Donaldson added.

Though headline risk has brought some negative attention to the municipal market, Heckman of U.S. Bank said the visibility has put a positive spin on a less glamorous segment of the fixed income sector.

"There is now more awareness of muni bonds," he said. "Some of the wrong headlines brought it into the spotlight, but those are situation that are more of the minority. The reality is muni bonds are a great place to invest for conservative investors."

Ciccarone said many credits have improved this year, even though there are still some highly visible -- and some not so visible -- weak credits that could produce negative headlines.

"General municipal bond credit factors are mostly favorable this year based on improved tax and fee revenues," he said. "That is not to say that there are no credit problems," Ciccarone added. "Puerto Rico stands out and there are a number of lower-tier credits, which remain under serious fiscal stress."

Going forward, he said direct municipal ownership by households will benefit from rising interest rates more than they will be hurt by isolated credit situations, like Puerto Rico.

"If interest rates go up significantly, it's likely that household purchase of munis will become much more popular as recent offerings will be able to offer the higher distribution yields than mutual funds, which are saddled by a plethora of lower-coupon securities."

Although overall credit conditions are stabilizing to improving, direct ownership could continue to decrease as a result of investor skittishness, Ciccarone said.

"The public is less confident in their own ability to pick out bonds they believe are lower risk even when there are ratings on these issues," he said. "Pension issues and concerns about the safety of a general obligation pledge contribute to investor and investment consultant anxieties about making the wrong choice at relatively low yields."

Meanwhile, the tapering off and end of the Fed's economic stimulus and a backdrop of lower Treasury yields should also boost ownership of municipals bonds by increasing demand for mutual funds in the near term, according to Mousseau of Cumberland.

"The further the taper tantrum is in the rear view mirror the more investors are comfortable with owning bond funds," he said.

For reprint and licensing requests for this article, click here.
Buy side
MORE FROM BOND BUYER