Households surpassed their previous record and hit a 20-year high as they hoarded $1.095 trillion of the nearly $3 trillion of outstanding municipal bond debt issued by states and local governments as of 2010, according to data recently released by the Federal Reserve.
Ownership by households grew by 4.9% in the fourth quarter of 2010 and by 8.5% throughout 2010, despite the blood-letting that was unfolding simultaneously in the municipal bond mutual fund industry.
“Households have rightfully chosen direct ownership of municipal bonds versus traditional open-ended mutual funds, which can suffer significant declines in their [net asset value] price should interest rates rise,” said Michael Pietronico, chief executive officer of Miller Tabak Asset Management.
“Those investors who own their own bonds have the advantage of riding out the rise in rates by holding bonds to maturity,” he added.
“Individual investors, identified in the Fed data as households, remain by far the largest group of muni owners,” Alan Schankel, Guy LeBas, and Tom Kozlik, analysts at Janney Montgomery Scott, noted in a recent report.
The wave of mutual fund selling began in November when managers scrambled to raise cash to meet massive redemptions.
It continued in December following nationally televised comments by Wall Street analyst Meredith Whitney, who predicted “hundreds of billions” of dollars in defaults by 50 to 100 municipalities in 2011 and triggered widespread panic among many muni fund investors.
“While mutual fund investors sold their muni funds late in 2010 and into 2011, the rise in interest rates that accompanied the mutual fund redemptions created attractive purchase opportunities for investors who could handle more risk,” said Chris Mier, chief investment strategist at Loop Capital Markets LLC.
“It is the difference in risk aversion that explains how one distribution channel is shrinking while a different channel for the same product is growing,” he said.
Municipals returned negative 7% from the end of the third quarter through the first two weeks of January 2011, according to a Standard & Poor’s index tracking the sector.
The investor panic reached a plateau when shareholders withdrew a record $4 billion from municipal funds in the week ending Jan. 19, according to Lipper FMI.
“Some of the outflows that have occurred from the mutual fund space have been a result of inflation concerns, and as such we are not surprised by the data from the Federal Reserve,” Pietronico said.
Through the fourth quarter of last year, mutual funds held $525.9 billion of debt, having declined $6.8 billion, or 1.3%, from the $532.8 billion they held through the end of the third quarter, which was the highest ever.
But some believe the presence of buyers other than traditional retail individual investors that were lumped into the household sector contributed to the substantial rise in the fourth quarter.
“This divergence in direct buying and mutual fund flows in Q4 2010 is likely driven by direct muni bond buying from non-traditional investors, which do not have a separate category under the flow of funds, and are included in the 'household’ sector,” one market observer said.
“Hedge funds and nonprofit organizations, such as endowment funds, are classified under the 'household’ sector,” yet they deserve their own category, he said.
At the same time, however, mutual funds managed to remain the second-largest holder of muni debt last year.
The $525.9 billion held by funds through the fourth quarter of 2010 represents an increase of $45.8 billion, or 9.5%, from the $480.2 billion through the end of 2009.
“Although holdings by mutual funds — and closed-end funds — tapered off in the fourth quarter, they nevertheless finished higher year over year,” the Janney analysts’ report said.
Back in the household sector, investors added $51.1 billion in municipal securities to their portfolios in the fourth quarter alone, more than half the $85.4 billion added in 2010.
Commercial banks, savings institutions, and life insurance companies were the other categories whose ownership of munis in 2010 showed the next largest growth, though modest compared to the little or no growth among other holders overall.
“Larger institutional investors such as commercial banks, savings institutions, and insurance companies will be more negatively affected by the negative credit headlines and as such may remain marginal buyers until the economy as a whole turns more notably upward,” Pietronico said.
“We look for significant gains in employment as a possible catalyst for more participation from this investor base” going forward, he added.
Commercial banks’ ownership rose by $27.5 billion — or 12.6% — to $246.1 billion through the end of 2010, compared with $218.6 billion in 2009. Ownership increased by $16.9 billion — or 7.7% — in the fourth quarter. Savings institutions, meanwhile, saw a 19.9% increase, or $1.8 billion, to $11.1 billion in 2010, up from $9.2 billion in 2009. In the fourth quarter, holdings only grew by $900 million.
Ownership by other muni holders only increased modestly over three and 12 months. Life insurance companies — the third-largest holder of munis last year — grew by $4.4 billion, or 6%, to $77.5 billion through the fourth quarter, up from $73.1 billion in 2009.
Broker-dealers, on the other hand, held $40 billion through the end of 2010 — a 12.9% increase from to the $35.4 billion they owned through 2009.
“Banks and insurance companies also grew their holdings, but they still have a market share below 25% compared to households’ 37%,” Janney analysts said.
Money market funds, meanwhile, decreased ownership of municipal bonds by a whopping $66.9 billion in 2010, ending with $334.4 billion, a 16.7% decline from $401.3 billion through 2009.
Ownership by money market funds peaked in 2008 when they held $494.6 million, according to the historical data.