What are muniland’s biggest players?

September 26, 2012

The retail investor is king in muniland, holding about $1.81 trillion of municipal securities in the second quarter of 2012, according to the Federal Reserve Flow of Funds report. But where are the other big players in the municipal bond market, and what are their investment objectives? Here’s a quick rundown of the different parts of the financial business that held $1.789 trillion in muni bonds in the second quarter of this year.

Securities dealers

Big bank dealers like Citi, JP Morgan Chase, Bank of America Merrill Lynch, Morgan Stanley and Goldman Sachs held a relatively small amount of municipal bonds this year, with $31 billion in the second quarter. But they play an outsized role in muniland. The dealer banks underwrite a vast majority of new municipal bonds, they write derivative contracts to municipal issuers and they control the flow of trading between market participants. Their basic advantage comes from knowing who bought bonds in the underwriting process, and who might be willing to trade old bonds out for new ones. Bank dealers hold their bonds typically as trading inventory. Securities dealers have decreased their holdings, down from $51 billion in 2006.

Government-Sponsored Enterprises (GSEs)

The GSEs held a tiny amount of municipal bonds, $19 billion in the second quarter. This number only seems tiny because the bonds somehow snuck onto the $6.351 trillion portfolios of GSEs. It makes me wonder if some traders there just made a mistake when choosing which bonds to buy.

Money market funds

Money market funds held $271 billion of municipal securities in the second quarter; about 18% of their total credit market instruments. Money market funds often purchase VariableRateDemandObligations (VRDOs) or TenderOptionBonds(TOBs), which are synthetically created by a bond dealer or otherparty with long-term bonds purchased in either the primary or secondary markets. These bonds are put into a trust, part of which is sold to a money market fund as a short-term, tax-exempt instrument whose yield is reset daily or weekly based on an index of short-term municipal rates. Dodd-Frank tightened the rules on TOBs, so they are likely to end in 2014 unless a structure is developed which evades the new rules.

Mutual funds

Municipal bond mutual funds are the big Kahuna in muniland, with $584 billion in the second quarter this year. Mutual fund managers do the hard work of managing credit risk (of default) and trying to stay in the best part of the yield curve. Several municipal bond mutualfundflowreports are watched closely each week to see if money is flowing in or out to muni funds. Like money market funds, mutual funds must be ready to redeem investor cash on demand. This makes managing these funds an art as a well as a science.

Property-Casualty Insurance Companies

Property casualty insurance companies are also big players in muniland with holdings of $329 billion in the second quarter. But unlike mutual funds and money market funds, P/C insurers typically have longer investment horizons since they don’t face sudden investor withdrawals. They do occasionally have to liquidate holdings if a natural disaster requires payouts to their insured clients.

I wrote incorrectly several weeks ago that P/C insurers couldn’t take advantage of the tax exemption of municipal bonds. Tom Metzold, senior portfolio manager of Eaton Vance, explained a special tax provision that does allow them to. This is the ACE provision, or adjusted current earnings provision, that allows property casualty insurers, when profitable, to own more than the 2% de minimis rule would normally allow. Metzold said as profits rise for P/C insurers they may own up to 10-15% of their investment portfolio in munis and exempt the interest earned from taxation if it follows the ACE provision.

Life Insurance Companies

Life insurance companies, the cousin to property casualty insurers, held $120 billion of muni bonds in the second quarter. Typically life insurers invest for the longest term, since they are matching their assets with their actuarially calculated liabilities (i.e. the life expectancies of those they insure).

The Federal Reserve

The Fed, although permitted by law to hold municipal securities that mature in less than six months, held zero muni bonds in Q2 of 2012.

U.S. Chartered Depository Institutions

U.S. banks, not including credit unions, held $327 billion in munis in the second quarter. This is almost double the $190 billion they held in 2006. As a Bond Buyer story noted, there is a great “carry trade” for banks that involving munis. Banks that have depositor money on which they pay 0% interest can buy munis paying 2-4% interest with those deposits, thus earning the spread between the two interest rates:

But conditions with interest rates have also been ripe for investing in munis, raising demand among banks. That is because banks’ cost of obtaining deposits and borrowing in the capital markets is very low, Decker said.

Thus, banks can borrow, or obtain deposits, at close to 0% interest. Accordingly, losing a portion of the interest-expense deduction for buying municipals — which is the tax penalty for earning tax-exempt interest — is not substantial, considering that banks pay little in interest expense anyway.

There is tremendous demand for municipal bonds. When you break down the major market participants, it’s easy to understand why muniland yields are at historic lows. The supply of municipal bonds is tight, and many players want their piece.

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