Mutual funds continue to be a dominant force in the municipal bond market, with tax-exempt assets of the funds growing to $161.1 billion during the second quarter of 1992.
The $15.6 billion rise in mutual fund holdings from the previous quarter means that for the first time in recent history the funds now surpass property and casualty insurance companies as the second largest holder of tax-exempt securities, according to the Federal Reserve's Flow of Funds Accounts.
While households continue to be the predominant holder of munis, with $578.1 billion of assets, mutual funds appear to be the primary beneficiary of a modest $8.9 billion reduction in tax-exempt assets from the household sector, several analysts said.
The outflow from direct retail purchasers is the first since the third quarter of 1989, according to the Federal Reserve data. Analysts cite the increase in bond calls prompted by recent historically low tax-exempt interest rates as the primary cause of the reduction.
"I'm not surprised by that. They're caught up in the bond call phenomenon," said George Friedlander, managing director of high net worth portfolio strategy at Smith Barney Harris Upham & Co.
In addition, declining municipal bond yields and subsequent investor "sticker shock" has kept direct purchasers on the sidelines, hesitant to put money back into the market at such low interest rates, Friedlander said.
"But smaller investors, with cash from certificate of deposit rollovers and money from money market-funds
have turned to the bond V3
fund," the strategist added.
Peggy Gartin, senior portfolio officer with John Hancock Advisors in Boston, pointed to the growth of mutual funds as a hindrance to small investors trying to purchase bonds.
"It's much more difficult for them to buy individual bonds now than it was there to four years ago," Gartin said.
The funds have become such a dominant player in the market that at times a fund company can buy entire bond issues, leaving no bonds available for individual buyers, Gartin said. "I've seen it happen a lot in the state of California. Some can buy the whole deal, so it's more difficult for retail to get their fair share," the portfolio manager said.
Underwriters in fact often have to allocate a certain amount of a bond offering of retail investors, to insure that bonds are available for them, Gartin said. "Otherwise, mutual funds would happily buy as many bonds as they can get.
"I think because of that, a lot of individuals turn to mutual funds when they would have preferred not to. It's an easy alternative."
A rise in short-term interest rates or in municipal bond interest rates over all would be needed to reverse the trend, which could show larger outflows from households in the third quarter, both Friedlander and Gartin said. However, the deterioration, which Friedlander calls "the collapse of the fixed-income portfolio" could continue for the next few years.
Asset flows show $64.7 billion moving into bond mutual funds in the second quarter. Meanwhile, assets of commercial banks continue to decline, with assets at their lowest levels since 1974. Commercial banks had tax-exempt assets of $98.9 billion in the second quarter logging an outflow of $7.5 billion.
"That is going to go on forever," Smith Barney's Friedlander said of the decline in commercial banks' tax-exempt assets.
Victimized by the Tax Reform Act of 1986, which placed stringent limitations on the types and amounts of tax-exempt bonds that banks could hold before bumping up against alternative minimum tax restrictions, commercial banks have steadily cut their holdings of municipals by not replacing them as they are redeemed or mature, Friedlander said.
Commercial banks were the largest group of investors in municipal bonds in every year but one from 1965 through 1986, according to the Federal Reserve data. Banks were overtaken by households as the largest sector holding tax-exempts in 1987, and then dropped to third behind property and casualty insurance companies in 1989.
Tax reform restrictions account for the diminishing role of property and casualty insurance companies, Friedlander said. Specifically, the alternative minimum tax reduces the total amount of municipals which a company can purchase. In addition, declining underwriting profits reduce the amount of cash a company has to purchase tax-exempts.
As a result, property and casualty insurance companies are mainly buying bonds "at a replacement level," merely replenishing portfolios depleted by redemptions due to bond calls, Friedlander said.
The flow of funds data also show that tax-exempt money market funds saw an inflow of $7.6 billion during the second quarter, slightly less than the $7.9 billion inflow seen by brokers and dealers.
Property and casualty insurance companies had $140.7 billion of assets during the quarter, and saw an outflow of about $400,000 in the second quarter.
In addition, state and local governments saw an inflow off $58.6 billion of tax-exempt assets in the second quarter.
