Banks ramped up purchases of municipal bonds in the first half of the year in the wake of federal legislation designed to stimulate banks' interest in state and local government debt.

Banks like to invest in municipal bonds, which under certain circumstances provide tax advantages, to protect profit from taxes and diversify their holdings. Banks owned $159 billion of municipals based on market value at the end of June, according to Highline Data LLC. That's a 7.9% leap from the end of 2008.

The accumulation of municipals in the first half of the year was driven by the American Recovery and Reinvestment Act, which was intended to make municipals more appealing and available to banks.

"It dramatically improved the economics for banks to buy munis," said Matt Fabian, managing director at Municipal Market Advisors. "It amplifies demand."

Under the Tax Reform Act of 1986, banks are prohibited from deducting the interest expense of holding municipal bonds, unless the bonds are designated "bank-qualified."

Last year, less than 4% of issuance was bank-qualified.

The law rendered most municipal bonds unprofitable for banks by effectively eliminating the tax exemption.

Enacted in February, ARRA contains two provisions urging banks back into municipals.

The first temporarily allows banks to deduct 80% of the interest expense on municipal bonds even if they are not bank-qualified, provided they constitute less than 2% of a bank's assets.

ARRA essentially reinstates most of the tax exemption on municipal bonds for banks.

"That certainly reinforces the growth in the municipal bond holdings for banks that are profitable and able to benefit from the tax deduction," said Richard Ciccarone, head of research at McDonnell Investment Management.

The second provision expanded the availability of bank-qualified bonds. Until this year, a bank-qualified bond was defined as a bond sold by an issuer that floats $10 million or less a year.

ARRA lifted the ceiling to $30 million for bank-qualified issuers. The volume of bank-qualified bonds has doubled this year as a consequence and now represents 9% of total issuance.

Both provisions are scheduled to sunset at the end of next year, although there has been some discussion of extending one or both.

George Friedlander, muni strategist at Morgan Stanley Smith Barney, said banks may be set to buy even more municipal debt as the sector becomes more profitable.

Many banks have yet to revert to profitability, meaning they have no reason to buy municipal bonds for their tax exemption.

He pointed out that bank-qualified issuance has outpaced bank buying.

Banks bought less than $8 billion of munis in the first half while bank-qualified issuance was more than $16 billion.

As more banks gain profits they would like to shield from taxes, Friedlander said they are likely to start bidding for the bank-qualified debt currently being purchased by retail investors and mutual funds.

Citibank Inc., which owns more munis than any other bank, added $1.98 billion to its portfolio, bringing the total to $17.85 billion.

The most acquisitive bank was JPMorgan Chase & Co., which bought $2.24 billion of munis to grow its portfolio to $3.17 billion.

Another big buyer was Bank of America, which added $1.2 billion to its portfolio, which now totals $11.72 billion.

According to Federal Reserve data, banks hold 1.5% of their $14.2 trillion in assets in municipal bonds and loans. That proportion is in line with the proportion over the last decade, but far lower than it was before the 1986 law on tax deductibility. Throughout most of the 1960s and all of the 1970s, banks held at least 10% of their assets in municipal bonds, according to the Fed.

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