Municipal bonds have a growing fan base: commercial banks.
Banks have been snapping up munis in the primary and secondary markets, as well as purchasing issuers' variable-rate notes and holding them on their own books, known as direct purchases.
In fact, banks have been increasing their holdings so much, they're now on pace to surpass both money market funds and property and casualty insurers to become the third-largest holders of municipal securities in the $3.7 trillion market by the end of the year, according to one industry analyst. At that point, they would trail only households and mutual funds, numbers in the Federal Reserve Flow of Funds show.
Industry watchers posit different opinions as to why this is so. Relaxed tax rules during the economic downturn in 2009 and 2010 freed up U.S.-chartered depository institutions, as they are categorized in the Fed report, to invest more in tax-exempt securities.
Others say that bank profits correlate with their muni bond investments: as one increases, so does the other.
Still another hypothesis holds that banks are looking for munis to compensate for reduced opportunities to lend in more traditional ways.
Regardless of the reason, the numbers point in one direction.
"Banks are increasing their exposure to the municipal bond sector," said Peter DeGroot, a muni strategist with JPMorgan. "It's clear that banks have enjoyed a growing depositor base.
They have a significant amount of capital to invest, and municipals present themselves, at times, as a relatively attractive fixed-income alternative."
The muni bond market has been shrinking of late as municipalities have issued less new-money debt. The Fed, in its Flow of Funds quarterly report released Thursday, said the muni market at the end of the second quarter totaled $3.73 trillion. The market has been contracting since 2010, when it peaked at just under $3.8 trillion in outstanding debt.
Commercial banks at the end of the second quarter held $327.4 billion. The banks have been boosting their holdings in municipal bonds steadily since the mid-1990s, according to Federal Reserve numbers.
By comparison, households, the largest group of muni bond holders, have seen their ownership numbers drop for five straight quarters.
That doesn't mean individuals aren't buying municipal bonds. Recently, much of their funds have been directed to mutual funds as nervous investors seek professional guidance and greater diversification. As a result, mutual funds have been boosting their muni bond holdings over the same period.
The numbers for holdings by money market funds have fallen since 2008. Property and casualty insurance companies' holdings of muni bonds have fallen more or less steadily since the end of 2008.
Wells Fargo Bank Sioux Falls, S.D., demonstrating a recent zeal for municipals, paced all U.S. banks in muni bond holdings last year, according to numbers from Highline Financial LLC. Over the previous two years, its muni holdings rocketed 1,239%, to $22.3 billion by the end of 2011 from $1.67 billion at the end of 2009.
Banks contacted for this story would not comment on their own muni holdings.
Municipal Market Advisors says that banks are on track to become the third-largest aggregate holder of municipal securities by year-end. For banks, munis represent investments that are "mostly safe, pay a good coupon, and imply local investment," said Matt Fabian, a managing director with the independent research firm.
Fabian said that, given current economic conditions, banks now see fewer opportunities to lend in more traditional ways — i.e. mortgages, industrial loans, etc.
Federal tax policy has played an important role when it comes to banks investing in munis, according to JPMorgan's DeGroot and Michael Decker, a managing director and co-head of the muni division at the Securities Industry and Financial Markets Association. Since the passage of the Tax Reform Act of 1986, banks have been discouraged from investing in all tax-exempt bonds save for the bank-qualified kind.
Banks can earn tax-exempt interest, Decker said. But a provision in the tax code decreed that, to the extent that banks earn tax-exempt interest, they lose a portion of their interest-expense deduction, he added. This causes a generally disadvantageous net tax effect when banks buy municipal bonds.
But in 2009, the American Recovery and Reinvestment Act opened the door for banks to buy more tax-exempts without incurring the tax penalty.
The provision enhanced the safe harbor rule for new-money securities issued in 2009 and 2010, according to DeGroot, and afforded banks the ability to deduct interest expense for the purchase and carry of municipal securities issued in 2009 and 2010 up to 2% of the total assets of the bank.
"So for 2009 and 2010, when that provision was in effect temporarily, banks were able to purchase significantly more municipals than they had before without a tax hit," SIFMA's Decker added. "Since 2010, the old regime has come back in place, and banks will take a tax hit when they buy municipals."
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.
Munis also look attractive when banks have strong quarterly performances, according to Richard Bove, a vice president of research at Rochdale Securities.
"Essentially, when banks are making money, they buy a lot of municipal bonds, because it protects their yield on assets," he said. "To some degree, they can take the benefit."
And bank profits have been soaring, Bove noted. Over the past 12 quarters, earnings have basically been up every quarter, year-over-year, he said.
"So, if you assume that muni bond purchases go in line with changes in profit," Bove said, "then there's a reason for them to buy muni bonds at the present time."