While Build America Bonds have limited the supply of tax-exempt issuance, strong demand from retail investors is also playing a vital role in lowering issuers’ borrowing costs to historic lows.
Indeed, with retail demand responding so closely to market needs, it’s become a truism to say that muni bonds are sold, not bought — meaning that demand from investors will be there if the marketing is right.
Traditionally, that marketer is a broker, underwriter, or financial adviser. But in a trend started by California launching a retail-oriented website in 2007, different forces in the market are using new websites aimed directly at the retail base to exploit the ongoing demand.
Tom Dresslar, spokesman for California Treasurer Bill Lockyer, said building a larger state market for individual investors was one of the administration’s priorities upon taking office in 2007. The key initiative, BuyCaliforniaBonds.com, launched in June 2007.
“By investing in these bonds,” Lockyer’s message on the site says, “you will help turn the projects you approved at the polls into reality — adding to our quality of life and the vibrancy of our economy.”
Accompanying the site’s launch was an advertising campaign on the web, print ads in California and New York newspapers, and some radio spots.
“The print ads, in terms of sophistication, were a big leap forward from the kind of tombstone ads that you’d normally see,” said Dresslar, who claimed the campaign was a success in drawing new demand.
Before June 2007, it was “extraordinary” to see one-fifth of the state’s issuance sold to individual investors, he said. Since then, the state has sold $43.3 billion of tax-exempt debt, with $23.5 billion, or 54.4%, going to retail.
“We’re proud of the number — it’s a huge chunk,” Dresslar said. “I don’t want to say 'unprecedented,’ but a large percentage of our bond sales have gone to retail.”
That large percentage helped the state keep costs low as it came to market with six of the 20 largest bond issues last year.
What California experienced is a microcosm of a drive towards retail in the broader muni market.
Chris Holmes and Alex Roever, fixed-income analysts at JPMorgan, Friday said the financial crisis “shifted the tectonic plates” of the market in a way that hasn’t been seen since tax laws were changed in 1986.
When the Reserve Primary Fund, a large money market fund, “broke the buck” in September 2008 — meaning that its per-share net value fell below par — holdings flowed out of money funds. Retail demand then propped up the market as institutions shed their holdings.
“As financial firms and investment banks had to become big sellers of munis and didn’t hold a lot of inventory, the market was looking for retail to pick up the slack, which they have,” said Phil Villaluz, head of municipal strategy at Advisors Asset Management.
When Build America Bonds entered the market last year, the creation of the taxable asset gave issuers the option of tapping into the broader fixed-income market, thereby limiting supply among tax-exempts. That alleviated pressure among issuers and underwriters to find retail buyers, as less supply helped to cap yields from jumping beyond historical norms.
Retail demand has kept apace even as yields fall to historic lows. The Municipal Market Data 10-year, triple-A scale yielded 2.57% late last month, the lowest in at least three decades.
Holmes and Roever noted that continued retail strength was on display last month.
When New York City planned to issue $800 million of tax-exempts, retail orders for almost $400 million allowed the city to bump up its offer to $997.8 million. Also, just before Illinois auctioned $1.3 billion of short-term notes, the minimum bid was cut to $5,000 from $100,000, a move the analysts presumed would attract a wider base of investors.
Retail participation “brings incremental demand in the best of times” and serves “as a critical buyer of last resort in the worst of times,” Holmes and Roever wrote Friday in a research note.
Recent trade activity from the Municipal Securities Rulemaking Board, they added, confirms this, “with lots of movement in $5,000, $10,000, and $20,000 blocks,” another indication that smaller buyers are active in the market.
Federal Reserve data indicates that appetite from retail has outpaced broader market growth in recent years. From the first quarter of 2008 to the first quarter of 2010, total outstanding municipal debt grew 4.6% from $2.708 trillion to $2.834 trillion, while household holdings jumped 8.9% from $937.7 billion to $1.020 trillion.
That surge pushed household holdings up from less than 33% of the market in early 2008 to about 36% in early 2010.
If “retail” is defined to include pension funds, mutual funds, and others who purchase on behalf of individuals, then households either directly or indirectly own more than two-thirds of the market.
Market participants say there is no sign of that demand abating.
“Business has definitely picked up with municipal bonds,” said James Grady, director of the fixed-income trading desk at TD Ameritrade. He said registered independent advisers, who purchase for retail indirectly, have also increased as investors become comfortable with more risk.
“Over the last 18 months, overall bond business at TD Ameritrade is essentially flat,” he added. “But municipal business is up 70%, whereas certificate of deposit and Treasury business is down about 60% and corporate business has also stayed flat.”
Andy Gill, senior vice president of fixed income at retail-oriented Charles Schwab, said his firm’s agreement in April to offer more municipal products via new issuance from JPMorgan has been met with great interest.
“In the first two months since the announcement with JPMorgan, Schwab clients have gained access to 10 times the muni new issues they had last year, and they have increased their purchases behind that,” he said.
Holmes and Roever wrote that the retail share of the market “would probably be increasing even more” if the Build America Bond taxable municipal market had not developed such a significant presence over the past year.
They noted that BABs are more popular with institutional investors. That implies that if Fed data distinguished between taxable and tax-exempt data, the growth in retail demand for tax-exempt bonds would be more remarkable.
Numerous reasons account for why retail buyers are seeking tax-exempt bonds.
One of the most cited is the aging investor base, as retiring baby boomers seek to preserve their wealth rather than risk it in stocks.
“The aging investor base is something that’s been discussed for the past 15 years,” Grady said. “I think the critical change is that the baby boomers are no longer going to retire — they are retiring. It’s no longer just an academic discussion.”
Gill added: “They are using fixed income not only for the income piece but also for the stability that it provides in their portfolio. It does not have the same volatility profile as an equity.”
Another reason is the widespread anticipated rise in tax rates.
The tax relief measures enacted under former President George W. Bush in 2001 are set to expire in January 2011. To help pay for Medicare, President Obama in March signed a bill which includes a 3.8% tax on wealthier Americans’ unearned income — such as capital gains — starting in 2013.
State and local rates could also rise.
“I don’t think anyone feels that the tax rates are going to decline,” Grady said. “There’s almost universal agreement that they are going to increase, particularly on the state and local level because of budget hardships.”
In light of these trends, Villaluz said it makes sense to see “more electronic marketing or sales platforms focusing on the retail investor and getting that tax-exempt product out in front of them.”
Assured Guaranty Ltd., the parent of the only two bond insurers writing new guarantee policies, offers one recent example.
The company launched an advertising campaign in April that includes one-minute radio spots and a new website: ThinkAssuredGuaranty.com.
The target audience is “broker-dealers, financial advisers, and their clients in order to be more responsive to the retail segment of the market,” the company said in an e-mailed statement.
The website provides an introduction to the value of bond insurance, a question-and-answer video with chief executive officer Dominic Frederico, and a series of billboard-style ads.
“Since approximately two-thirds of municipal bonds are owned by individual investors either directly or through mutual funds, we believe it’s important to make sure that our financial guaranty product is well understood at all levels of the municipal marketplace,” the company said.
An investor does not have the option to purchase insurance on individual issues — that’s left to the issuer and underwriter to decide — but if more people buy insured bonds, it will tighten in spreads versus uninsured bonds. Lower spreads will save the borrower money and thereby make insurance more attractive to state and local issuers.
It’s probably too early to see if the campaign is working, but Assured did back 7.2% of new issuance last month, compared with 6.7% year to date. The company said feedback from the sales and trading desks “has been very positive.”
Jennifer Galloway, chief communications officer at the MSRB, said the trend to give investors more information is helpful to everyone involved, advisers included.
“The more information investors have, the better,” she said. “The more informed they are, the better the relationship they can have with an investment professional.”
Galloway said more education empowers the investor base, “but it doesn’t mean they don’t need an investment professional. It just puts them into a better position to have strong and meaningful conversations with their investment advisers.”
In line with that trend, the MSRB website was recently overhauled to give more educational material to investors. Galloway said the new design was
intended to encourage all investors to be more knowledgeable about what they are investing in.
Andy Nybo, principal at TABB Group, a financial market research and strategic advisory firm, agreed that the work being done to educate investors is good for the whole market and doesn’t threaten the financial adviser community.
He said new tools and web platforms can be effective in giving individual investors the tools for research, but the actual purchasing of bonds still tends to be done over the phone with the help of an adviser.
“The broker is essential to the process providing information on color, on market circumstances, on the issuer, on the prospects of that bond issuer,” Nybo added.
At TD Ameritrade, which offers e-trading, Grady said web-trading of munis is certainly bigger now than in 2008, but that the bulk of his clients like to talk to someone first rather than to begin purchasing with the click of a mouse.
“It’s not quite the mover and shaker that some may have assumed,” he said of retail e-trading. “It’s certainly just a small part of the business we see.”
Richard Ryffel, managing director of investment banking at retail-oriented Edward Jones, said online platforms serve a different clientele and will not upset the relationship-driven adviser model — what he called “the antithesis of online.”
“We don’t think people should do it themselves,” Ryffel said. “We think people should get advice both in order to get information but also to assist them with investing discipline. If someone wants to do it themselves, that’s just not a Jones client.”
Richard Ciccarone, managing director and chief research officer at McDonnell Investment Management, added that the current volatile climate makes it particularly tough for retail buyers to jump into the market.
“It’s very difficult for individuals to be able to dissect a particular bond issuer to know there’s an underlying weakness in it,” he said. “From that standpoint, bond selection is more important than ever. Individuals who are left to their own devices are vulnerable. They aren’t necessarily in a position to do that on their own.”
The decision earlier this year by Moody’s Investors Service and Fitch Ratings to recalibrate ratings to a global scale, giving thousands of issuers a ratings boost, has also made things more complicated.
On the one hand, the mass of de facto upgrades could make retail investors more comfortable with purchasing bonds on their own. However, the recalibration also had the effect of narrowing the spectrum of ratings.
“In many ways, that’s made it more difficult,” Ciccarone said. “Not all double-As are of the same quality. It makes a greater case for more professional investing.”
If there is any tension between go-it-alone investors and financial advisers, it could be exacerbated in coming years as retail demand continues to expand.
Holmes and Roever cited research indicating the alternative minimum tax could be restructured “to avoid it from applying to an additional 21 million taxpayers on their 2010 taxes.”
That, added with the Bush tax cuts likely expiring, could encourage demand for tax-exempt paper, they noted.
“It’s no longer just a product targeting the wealthy,” Villaluz added, speaking of tax-exempt munis. “It’s going to be something that’s applicable to middle-class or middle-income earning individuals.”
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