Retail share of muni ownership continues to increase

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Mutual funds gobbled up another $27.6 billion of municipal bonds in the final quarter of 2019, part of a trend of increasinging retail participation spurred by the 2017 tax reform.

That development is apparent courtesy of the quarterly flow of funds data released by the Federal Reserve Thursday.

Quarterly flow of funds data the Federal Reserve released Thursday offers insight into the composition of municipal bond ownership.

Mutual funds held $832.8 billion of munis at the end of the fourth quarter of last year, the Fed data showed, up from $805.2 billion the previous quarter and sharply up from $693.6 billion at the end of 2018.

Combined with modest growth in the household sector and declining or flattening bank ownership, the numbers support the narrative of a continued flight of munis to retail investors.

“Market demand now is more and more concentrated in the hands of individual investors,” said Patrick Luby, senior municipal strategist at CreditSights.

Beginning with the Q4 2018 release, the Federal Reserve switched to estimating household ownership of municipal bonds at market value instead of book value and also adjusted historical data back to 1996.

Luby said the change in methodology was a step in the Fed's effort to report all holdings data at market value. All of the major categories of municipal bond ownership are now reported based on market values, which Luby said makes it impossible to say precisely how much of the changes in ownership are due to buying or selling as opposed to changes in valuation.

Despite that, however, the Fed flow of funds is still useful for showing muni ownership trends.

Households and non-profit organizations held $1.894 trillion in municipal securities, a modest increase from last quarter’s $1.893 trillion of holdings. Both the household sector and mutual funds, considered sectors of the retail market, have been showing general trends of growth since the enactment of the 2017 Tax Cuts and Jobs Act.

The tax law cut the corporate tax rate to 21% from 35%, which made municipal bonds less appealing for banks and caused them to reduce their holdings continuously until this quarter.

Market analysts have said that many of the bonds being sold by banks were winding up in retail accounts. Luby said he believes the growth of retail participation, including through separately managed accounts, is a contributing factor to contemporary market volatility.

Muni holdings at U.S.-chartered banks were $471.8 billion, a slight increase from $469.9 billion in the third quarter. Muni market advocates are pushing for lawmakers to lift the cap on bank-qualified bonds to $30 million from $10 million, which would theoretically create a stronger market for bank buyers of munis by increasing the number of issuers able to sell bonds to banks on a favorable basis.

Banks are allowed to deduct the carrying cost of bonds designated as bank-qualified, giving them stronger incentive to own munis despite the changes to the tax law at the end of 2017.

The total size of the muni market was $3.855 trillion, according to the Fed data, up from $3.815 trillion the prior quarter. That’s the most munis on the books since the market stood at $3.860 trillion in the second quarter of 2018.

Exchange-traded funds continued a trend of growth in their muni holdings as well, coming in at $49.3 billion at the end of 2019. That was up from $45.4 billion the prior quarter, and $37 billion at the end of 2018.

The impact of the COVID-19 virus would not have been apparent on this latest quarterly report, as the illness had not reportedly spread beyond a particular area of China until this year. The next flow of funds report, due out June 12, will show ownership trends under the influence of what has now been classified by health officials as a global pandemic.

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