Retail investors are keeping their powder dry, holding money out of the municipal market as they wait for the Federal Reserve Board to make good on its promise of higher interest rates, municipal managers said.
"There is an expectation and hope for higher rates, but no urgency to put cash to work," said Peter Delahunt, managing director of the municipal bond department at Raymond James & Associates. "The frustration continues to keep cash either on the sidelines or in the short part of the curve, with some throwing in the towel to move out the curve, or down in credit to capture more yield."
The fund managers report a palpable absence of retail participation in direct bond purchases as issuance has picked up in recent weeks. With year-to-date supply down approximately 12% and estimates of net negative supply for 2014 ranging between $30 and $40 billion, historically low municipal to Treasury ratios and headline risk are also contributing to the pull back.
"People are not in love with the rates and they are worried about when the Fed starts to tighten," said George Friedlander, chief municipal strategist at Citi in an interview on Monday.
In the meantime, many investors are keeping their assets liquid and waiting for the right opportunity to invest, the muni managers said.
"When municipal bond supply does move higher and yields grind higher, in light of that, we see retail investors becoming more engaged in spending cash and locking in higher yields," Michael Pietronico, chief executive officer at Miller Tabak Asset Management in an email on Monday.
He said traditional retail investors are reining in the duration - or interest rate sensitivity - of their portfolios and have higher cash weightings than the historic norm.
"The typical investor that buys their bonds through a retail broker is letting the cash pile up," Friedlander agreed. "There is so much cash on the sidelines, it adds to the cash that's already there."
At midyear, household ownership of individual municipal bonds was at its lowest level since the first quarter of 2006, according to the latest flow of funds data released on Sept. 18.
The household sector, which includes retail, reduced its holdings of municipal bonds to $1.602 trillion in the second quarter of 2014, from $1.609 trillion in the first quarter. That compares to the $1.665 trillion held in the second quarter of 2013.
Andy Chorlton, portfolio manager at Schroders Investment Management North America, said declining rates prompted the reduction in household ownership.
"The universe of municipal bonds is shrinking" in a trend that surfaced after the 2008 financial crisis, Chorlton said in an interview on Tuesday.
Massive outflows from municipal bond mutual funds over 31 consecutive weeks in 2013 was a sign of that withdrawal, Chorlton said.
That trend reversed this year. Muni funds have reported inflows for eight straight weeks, including a $235.5 million gain in the week ended Oct. 1, according to Lipper FMI.
Still, "the money that came out of the municipal market last year on the back end of interest rate fears hasn't come back," Chorlton said.
A 2.3% increase September volume was met with strong demand, with some deals oversubscribed, yet the retail pace is still sluggish overall, managers said.
"Retail seems consistent, but slow," Delahunt of Raymond James said.
"There is a lot of cash on the sidelines right now waiting for anything with some spread to it - especially if it is a different name," or structured with 5% coupons rated A or better, Delahunt added.
Chorlton agreed that retail participation is waning.
"In the last few months, there was strong outperformance of municipals versus other asset classes, but there was not a big inflow of retail," he said.
In addition, Friedlander said the market lacked the "groundswell of extra demand" in specialty states that typically surfaces in June, July, and August to meet summer reinvestment needs.
"People are not in an urgent hurry when their bonds come due to get that money immediately reinvested," Friedlander said. "The psychology is they will reinvest when it makes sense to buy and when they feel there is something attractive, and they have no problem waiting."
Meanwhile, municipal-to-Treasury yield ratios currently on the lower side of historic norms are another barrier for many investors, experts said. For instance, the five-year municipal bond yielded 69% of its Treasury counterpart on Thursday, while the 10-year was at 88.3%, according to Municipal Market Data.
The 10-year is closer to its normal level over the past decade, the five-year is well below its 10-year norm of 87%, Friedlander pointed out.
"If we see percentages back to 100%-plus of Treasuries in 10 years our inquiries will grow dramatically," Delahunt of Raymond James said. "We still have some investors that are staying on the sidelines waiting for a better entry point."
Chorlton said many investors are letting their municipal positions roll off due to the low absolute yields and headline risks, but that the accumulation of cash could be viewed as a positive trend for the market.
"There is longer-term support because some of that cash will work its way back into the municipal market," he said.
Friedlander noted that household ownership of municipal debt began slipping in 2012 when rates were "painfully low" and holdings paled in contrast to the $1.871 trillion households held at the end of 2010.
Investors continue to be patient and hope for higher rates.
But Chorlton pointed out that the wait has been long, and investors are sacrificing value and income in the tax-exempt market in the meantime.
The Federal Reserve has held its benchmark rate at between 0% and 0.25% since Dec. 16, 2008, waiting for the economy to improve, and has recently been reducing economic stimulus by $10 billion monthly in a program that is slated to end this month.
"If you're a client that needs tax-free income your incentive to buy bonds has gone up in the last 12 months," Chorlton said. "We think relative to other classes, munis still offer value for higher-rate tax payers."
For instance, he said clients are earning a taxable-equivalent yield of 4% on the long, high-quality spectrum of the municipal market. While he said rates are not as cheap as they were six months ago, "people have given up an awful lot in the last five years," Chorlton said.
"Individual investors need to decide how long they are willing to stay on the sidelines," he said.
Christine Albano is a reporter for The Bond Buyer
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