What Do Supply/Demand Trends Signal for the Muni Market?

While investors have plowed more money into municipal bonds and related investments, the pace of issuance has slowed.

Overall, municipal bond investors had a positive experience during the first seven months of 2019, with the broad Bloomberg Barclays Municipal Bond Index earning a total return of approximately 6%—a number well beyond forecasts for the year. Against that backdrop, we believe it is important to examine the dynamics affecting the market and where things stand today.

Our focus will be on municipal market-specific dynamics rather than global interest rate changes which have clearly pushed yields lower.  With individual investors dominating the municipal bond market, the most important factors to consider are the components of demand and supply, in our view.

On the demand side, the municipal bond market has recently seen record inflows.  According to Lipper, municipal bond mutual funds have recorded more than $52 billion of inflows through July 24.  This is a record amount for the January-July period since Lipper began calculating flows in 1992.  To put this in perspective, through the first nine months of 2018, muni-bond funds saw $12 billion of inflows, which at the time was viewed very positively.

One additional difference between 2018 and 2019 is that investor demand for longer maturities has been strong in the current year, with more than $32 billion going into long-term funds. Last year, more money flowed into short and intermediate funds, reflecting concerns about rising interest rates. This year, individual investors appear much more comfortable with the rate environment.

Mutual-fund flows are only one way to measure retail investor demand, because people also invest money in munis via separately managed accounts (SMAs) and the purchase of individual bonds.  While there are no industry statistics for SMAs, through our experience and anecdotal evidence, it is clear that demand appears as strong for SMAs as it is for funds. There is one key difference: SMA holders appear to be more diversified by investing more in intermediate- and short-maturity munis.

A Deeper Dive into Muni-Bond Demand
Additional insights on muni demand can be gained by looking into the composition of the universe of bondholders.  The U.S. Federal Reserve (Fed) publishes quarterly data outlining the categories of municipal bond holders, and the most recent information, published in May, detailed holdings at the end of the first quarter of 2019.  As of March 31, 2019, there was $3.815 trillion in municipal bonds outstanding. At the end of 2017 there was $3.878 trillion outstanding, a decrease of more than $60 billion over the past year and a half.  This means that new bond issuance is lagging the amount of bonds that are maturing. One big factor here was the U.S. tax bill enacted in late 2017, which eliminated the ability of municipal bond issuers to advance refund outstanding bonds.¹  These types of bonds used to typically represent approximately 20% of new bond issuance.

Another interesting statistic in the data is that the amount of municipals owned by mutual funds has been increasing.  This has been a trend for a number of years.   For example, at the end of 2015, mutual funds held $604 billion of municipal bonds and that number has now increased to $739 billion.  According to Fed data cited in a July 24 Wall Street Journal report, municipal bond mutual fund holdings have increased by more than 50% since 2009.²  There are many reasons for this increase such as one primary factor being the decision by the Municipal Securities Rulemaking Board (MSRB) to require more detailed disclosure of the mark-ups on sales of individual municipal bonds to individuals.  This created more incentives for financial advisors to avoid these complications by putting clients into mutual funds instead of individual bonds.

The other major source of individual investor holdings is what the Fed refers to as holdings by “households and nonprofit organizations.”  This is a complicated number to analyze because it includes both SMAs and individual bond holdings in brokerage accounts.  Since the end of 2015, this number has decreased from $1.885 trillion to $1.875 trillion.  It actually dropped to $1.819 trillion at the end of the third quarter of 2018 and has risen since then. The interesting factor here is that we know that there has been a dramatic increase in SMA assets over this time even though the amount in this category has decreased.  Therefore, this means that individual bond holdings have been falling at a much faster pace while SMA and fund assets have been increasing.

According to data from Lipper, there are a lot of mutual fund complexes which offer municipal bond funds, but only a small number of them have been receiving the strongest flows.  Fortunately, Lord Abbett is well into the positive category (as of August 5, 2019) but some peers have seen outflows despite the record pace of inflows.

At the high end, a handful of fund complexes have been receiving the largest inflows.  According to a recent Bloomberg article, the largest firm has received approximately 32% of the inflows year to date through July 23.³  While this may seem impressive, that firm’s inflows of about $13 billion have had to be invested into a market where the total amount of new bonds issued was only $166 billion as of the end of June.  This means that the leader would have needed to buy almost 10% of all new bonds if it was relying solely on the primary market to invest new money.  In reality, the necessity of reinvesting proceeds of maturing bonds, and coupon payments from its funds, meant that this firm had additional money to invest, so it probably would have needed to buy more than 10% of the new issues.  While they might also use the secondary market, large investors may need to make adjustments in their selection process when making new investments in order to get fully invested given the large volumes of money they need to put into the market. There are a couple of other firms with outsized inflows in specific categories such as high yield municipals which might face similar challenges.  Investors should consider these market dynamics, and each firm’s ability to scale their security selection process, as they choose a muni manager.

What’s Keeping a Lid on Muni-Bond Supply?
On the supply side, the amount of new bonds being issued is well behind the pace of prior years, in part because of the 2017 tax bill.  With $166 billion issued this year through June, this is well behind the $211 billion issued during the first half of 2017 according to The Bond Buyer.  At $45 billion less, this means that there have been almost $2 billion less per week in new issues.

Many people keep mentioning that more municipal financing is necessary because the United States has significant infrastructure needs, but through the first six months of the year, new money issuance, which is for new projects, is down 3.6% from last year.  This reduction is occurring despite tax receipts coming in much higher than previous years, creating surpluses in many states such as California, New Jersey, and New York.  Instead of increasing borrowing, these states have been depositing excess proceeds into rainy-day funds to prepare for times when the economy might slow down.

There are some other supply constraints that municipal bond investors should be aware of, especially those looking for state-specific or state-preferential investments.  In California, new issue supply is down about 6% from 2018.  That might not sound like a lot, but considering how much higher demand is because of the impact of the SALT cap, this has created more of an imbalance.  In New York, supply is down 19% compared to last year.  Among other notable state issuers, supply is down 27% in Georgia, 34% in New Jersey, and 15% in Connecticut.  Many other states have lower issuance too.  On the positive side, Michigan is up 71%, Arizona is up 100%, Florida is up 120%, Indiana is up 200% and Maryland and Wisconsin are both up 30%.  (All issuance data herein are from The Bond Buyer.) Still, many of the states with the biggest increases in demand due to the SALT cap are seeing reduced supply.

Summing Up
The municipal bond market had a very strong seven months to start 2019.  All parts of the market have been performing positively while overall credit quality has remained robust.  Demand has been strong from individual investors, and shifts in the way they are investing have created some very interesting dynamics in the muni market.  The tax bill has increased demand while also reducing supply, which we believe creates positive market dynamics now and into the foreseeable future.  On the state level, many which typically have the highest demand from individual investors are seeing the largest supply challenges.

Even as market conditions change, the benefits from the tax exemption of municipal bond interest have remained constant, and the positive performance in the sector has greatly benefited investors. We believe the factors mentioned above are likely to continue to provide solid support for the municipal bond market.

¹Advance refunding refers to when one bond issuance is used to pay off another outstanding bond. The issue of the new bond is at a lower interest rate than the older, unpaid obligation. Advance refunding was a common feature of the municipal bond market until it was eliminated under the 2017 U.S. tax bill.
²Heather Gillers and Gunjan Banerj, “The Municipal-Bond Market Is Now Controlled by Just a Few Firms,” The Wall Street Journal, July 24, 2019.
³Danielle Moran, “Vanguard, Nuveen, Goldman Win the Fight for Cash Flooding Muni Funds,” Bloomberg, July 23, 2019.