Muni bonds shift to retail investors as bank holdings decline
Retail investors are gobbling up municipal securities as bank holdings of munis continue to decline.
Those developments emerged in the quarterly flow of funds data released by the Federal Reserve Friday. Bank holdings fell to $476.4 billion in the second quarter of 2019 from $491.1 billion in the first quarter of 2019, about a 3% decrease. Experts say the decrease is leading to more holdings by retail investors and their proxy , mutual funds.
Households and non profits organizations held $1.892 trillion in municipal securities, an almost $6 billion increase from last quarter. Mutual funds also had an increase of about $35 billion. Mutual funds held $737.2 billion in the first quarter and held $772.7 billion the second quarter of 2019.
"A lot of the bonds that banks are selling are ending up either directly in retail accounts or in mutual funds,” said Michael Decker, a longtime muni lobbyist and researcher.
The shift is due to a change in yields in the past six months, making munis more attractive to retail investors, Decker said. Trading conditions are also pretty healthy because there is more liquidity.
After the enactment of the Tax Cuts and Jobs Act in 2017, banks reduced their holdings by about $100 billion, Decker said. The tax law cut the corporate tax rate to 21% from 35%, which has made municipal bonds less appealing for banks.
Lifting the cap on bank-qualified bonds would help increase their holdings in municipal bonds, Decker said. In July, Rep. Terri Sewell, D- Ala., introduced legislation to increase the amount of tax-exempt bonds from $10 million to $30 million that local governments or nonprofits can issue and still qualify to sell debt to banks under more favorable terms as bank-qualified.
The limitation on bank-qualified bonds has not been indexed for inflation, which makes it less attractive for banks, said Patrick Luby, senior municipal strategist at CreditSights. Luby was not surprised that bank ownership continued to decline.
“The Fed data looks exactly like you would expect the Fed data to look,” said Matt Fabian, partner at Municipal Market Analytics.”It shows exactly the trends that everyone has been talking about.”
Post TCJA holdings are skewing away from banks and in favor of mutual funds, Fabian said. Mutual funds are then owning a larger share of the municipal market, following tax legislation that creates a larger incentive to own tax-exempt bonds for individuals.
“It’s also reflecting a secular movement to lower fee providers in the space and away from traditional transactional retail,” Fabian said.
The shift to retail investors and mutual funds leads to ownership diversification and more of a reliance on mutual fund investors.
“If mutual funds were to stop buying so many munis, prices would likely need to fall to attract nonmutual fund buyers,” Fabian said.
Retail broker-dealers have also shifted away from traditional retail accounts into managed money, such as mutual funds. Traditional retail can be expensive, Fabian said and be more erroneous due to more rules of how bonds are placed into retail accounts and increased disclosure.
Exchange-traded fund muni holdings doubled over the past four years, making it the biggest ETF number so far at over $41 billion in the second quarter of 2019. Fabian said though it’s still a relatively small number, they are growing rapidly.