The municipal bond market grew in the second quarter as household and exchange-traded fund ownership of municipal securities rose, while ownership by mutual funds, U.S. banks and life insurers fell, the latest Federal Reserve data shows.
The second quarter data showed the face amount of munis outstanding climbed 0.4% quarter-over-quarter, or $15.5 billion, to $4.043 trillion.
Since 2005, total muni debt is up 30%, compared to an 87% jump in the size of the corporate market and an almost 500% surge for U.S. Treasuries, said Pat Luby, a CreditSights strategist.
However, the average price of outstanding munis is now 97 cents, down from 98 cents in Q1 2023, the data show.
Meanwhile, the market value of munis fell 0.3% quarter-over-quarter, declining $10.8 billion to $3.941 trillion, as “the yield to worst for the ICE Muni Index rose 25 bp (from 3.39% as of March 31 to 3.64% as of June 30),” Luby said.
Household ownership of individual bonds — which includes direct ownership of individual bonds in brokerage accounts, fee-based advisory accounts or separately managed accounts — remained the largest category of muni ownership at 43%. Household ownership of munis rose $11.9 billion, or 0.7% quarter-over-quarter, to $1.695 trillion.
Mutual funds owned 19.4% of the market at $762.9 billion, 0.3%, or $2 billion less than in Q1. Net mutual fund flows for the quarter were negative $2.3 billion, according to the Investment Company Institute.
Exchange-traded funds saw ownership rise 1.4%, or $1.5 billion from the first quarter to $107.2 billion. This included net inflows of $2.3 billion for Q2, according to ICI. ETF investors account for 2.7% of muni ownership.
U.S. banks held 13.9% of individual bonds in the second quarter, at $548.3 billion, down $18.5 billion or 3.3% quarter-over-quarter.
Insurance companies — property and casualty and life — had 10.8% ownership, at $424.8 billion, a 5.9%, or $13.2 billion, drop from the prior quarter.
The latest Fed data was relatively unsurprising and confirms many of the trends in the market, Luby said.
“Anecdotally, individual investors remain the most important participants in the municipal market and the providers of liquidity, and that’s coming through SMAs and ETFs,” he said.
But while munis are priced to perfection for individual investors, he said, “banks and insurance companies are priced out of it, and so their holdings have declined.”
“We would expect that bank and insurance company holdings will continue to decline because of the appetite from individual investors,” Luby said.
SMA and ETF growth
There has been evidence of money moving from mutual funds into separately managed accounts and exchange-traded funds. However, on the surface, the data for Q2 does not necessarily show this.
Mutual funds showed only a slight decrease quarter-over-quarter and ETFs only a slight increase.
The movement from mutual funds into ETFs, though, is better seen year-over-year as mutual funds fell $60.2 billion, or 7.3% from Q2 2022 and ETFs rose $17.3 billion, or 19.2%, over the same time period.
Additionally, mutual funds’ ownership of munis fell to 19.4% in Q2 2023 from 20.7% in Q2 2022, while ETFs’ ownership of munis grew to 2.7% from 2.3% over the same time period.
It can be difficult to determine how much money is leaving mutual funds and entering SMAs. While the Fed does not break out SMAs from the household ownership category, the small uptick in household ownership can be attributed to the growth of SMAs, said David Litvack, a tax-exempt strategist at the chief investment officer at BofA.
“Many investors have been moving out of mutual funds because rates keep rising and they keep taking losses,” he said.
Litvack added, “a lot of investors have been also harvesting those losses for tax purposes, and then wanting to maintain exposure and the asset class they’ve gone into is ETFs because they’re a cheaper vehicle.”
Investors are looking to ETFs not only because of lower fees, but because they offer similar yields with lower volatility, said James Pruskowski, chief investment officer at 16Rock Asset Management.
SMAs have “become quite a force,” said Jeffrey Lipton, managing director of credit research at Oppenheimer, “thanks to an ever-cumbersome compliance/regulatory framework for broker/dealers.”
“We are seeing active bids committed to front-end-ish paper where SMAs have demand against a backdrop of supply shortages, with the value play finding it hard to gain traction,” he said. “While the long end may be more attractive, the needs of SMAs seem to outweigh a pure value play and we can expect this trend to capture greater momentum.”
Despite money moving out of mutual funds, they still make up the largest component of the fund vehicle class — mutual funds, money market funds, close-ended funds and ETFs — with 71.1% of all fund holdings and 19% of all holdings in Q2 2023, Lipton.
And while mutual funds “remain an important, enormous holder of muni assets,” Luby said, the net flows continue to be unimpressive.
The relatively flat nature of mutual funds quarter-over-quarter has “deprived the muni market of direction,” said Matt Fabian, a partner at Municipal Market Analytics.
“These days, they need the mutual funds to propel price prices one way or the other,” he added. “So without convincing mutual fund flows, the market lacks price momentum and price validation, and it makes other market participants, particularly retail, more hesitant to invest.”
Banks and insurance companies fall
As expected, banks trimmed their bond exposure, falling nearly $20 billion, and while insurer holdings also declined — property-casualty holdings dropped by about $9 billion and life insurers by about $4 billion, Barclays strategists said.
This was the second consecutive quarter the value of bank and insurance holdings have contracted, Luby said.
The banks and insurance companies continue to “allow their ownership to run off,” as munis have not been attractively priced for those types of investors, he said.
Fewer investors were “subject to the maximum federal individual income tax rate of 37%” in the quarter, “as tax-exempt yields were rich, compared to comparably rated corporate (and taxable muni) bonds,” Luby said.
For example, assuming a 21% tax rate, he said “the BVAL 10-year single-A tax-exempt yield ranged between 63 and 105 basis points lower than the after-tax yield of the single-A corporate benchmark yield.”
Furthermore, Litvack said, munis are still rich, and “until they cheapen versus taxables, banks and insurance companies will continue to reduce their holdings.”
Lack of supply is keeping munis rich, he said, and he doesn’t expect supply to ratchet up until rates come down.
Issuance is down year-over-year. Total issuance through August was $244.677 billion, down 15.1% from $288.204 billion through the same timeframe in 2022.
Several factors have contributed to the drop in issuance, including the 2017 Tax Cuts and Jobs Act — which eliminated taxable advanced refundings — and rates being so high that current refundings are not happening, as bonds get extended rather than refunded on a current basis, he noted.
Additionally, Litvack said, issuance has been slow because issuers “still have the money sloshing around from COVID packages and high tax receipts received during 2021 to 2022.” So many potential issuers are choosing to fund capital expenditures from internal funds rather than issuing debt, he said.
Furthermore, he noted, the latest information from the Fed that rates will stay higher for longer will have “a dampening effect on the refundings and, to some extent, on new-money issuance because it’s cheaper for issuers to use internal funds than sell debt.”
“Until we see new-issue supply pick up and/or current refundings pick up, munis are going to remain rich, and corporations, banks and insurance companies aren’t going to be participating as much,” Litvack said.