A form of patriotism perversely inspired by the financial crisis? Or an expression of self-interest spurred by the desire to limit future tax bills? Whichever motivation you ascribe it to, demand for municipal bonds by individual investors is up—and state and local governments are taking new steps to satisfy it.
State and local governments have increased their efforts to market muni issues directly to retail investors—taking out ads in newspapers and doing radio promotions—instead of letting them find brokers to sell the bonds to them after the initial offering at a markup. Boosting interest among retail investors has been a matter of survival for some states since the collapse of muni arbitrage funds and the retreat of other institutional buyers in early 2008.
Muni arbitrage funds were a vehicle for hedge fund managers to buy long-dated, fixed-rate muni bonds, and then use the coupon payments as collateral to back floating-rate bonds the funds would sell to investors. These funds had accumulated $160 billion to $180 billion in assets by the end of 2007, when many of those strategies began to falter, according to Matthew Posner, a director at Municipal Market Advisors, a Boston-based independent strategy, research, and advisory firm in the municipal bond industry.
"There are a lot more retail order periods [windows for retail investors to buy munis] than there used to be," says Posner. "Issuers are clearly making more time available for retail investors, linked in part to the lack of institutional demand, because that really started to happen after [the muni arbitrage fund] buying disappeared."
Institutional demand has been building back up over the past two or three months, however, as a result of an increased allotment for muni bonds on banks' balance sheets under the federal stimulus bill passed in February, he says.
Robust Demand for California Bonds But some states became more attentive to the needs of the retail market before the credit crisis hit. Delaware began to allocate 20% of its issues to individual investors in January 2005, and California Treasurer Bill Lockyer made greater access to munis for retail investors one of his campaign promises in 2006.
Retail investor demand for California state munis has been surprisingly robust since the state launched a direct marketing effort in June 2007, despite the state's well-publicized fiscal woes and the fact that its general obligation bonds have the lowest investment-grade rating of any state GO bonds in the U.S.
A cornerstone of California's program is www.buycaliforniabonds.com, a Web site that provides a list of approved brokers with whom investors can set up accounts, and answers basic questions concerning tax exemptions, risk, and how to interpret credit ratings. California caps retail orders at $1 million, with larger orders requiring prior approval by the state, its financial adviser, or the senior managing underwriter.
Making more room for individual investors ultimately benefits taxpayers by lowering the interest rates California pays bondholders. Retail demand was so high on a couple of offerings that the state was able to reduce the yield at pricing time with institutional investors, says Tom Dresslar, a spokesman for Treasurer Lockyer. "So we have no doubt it's accomplishing its objectives," even though it's hard to quantify exactly how much the state is saving.
One of the purposes of the program is to instill in Californians "a patriotic—for lack of a better term—sense of investing in California's future by buying bonds," he says. "Our voters have approved umpteen billion dollars of infrastructure bonds, so they clearly have seen the need to make that investment and this initiative is a way to take it to the next level."
Patriotism or Greed? In March 2008, retail investors bought half of a $1.75 billion issue of general-obligation infrastructure bonds and the following October they bought nearly 80% of a $5 billion issue of Buy California Bonds—short-term revenue anticipation notes for state budget needs that must be repaid by the end of the fiscal year in which they're sold—yielding 4.25%, says Dresslar.
Nancy Kopp, the Maryland State Treasurer, also sees an element of patriotism in the excitement people expressed in being able to invest directly in state bonds. She heard retail buyers say they felt it was much more empowering to buy munis directly than investing in them via a mutual fund.
Jim Colby, senior muni strategist and portfolio manager at Van Eck Global, doubts that "patriotism" accounts for even 10% of retail investor demand. "They know income from munis is federally tax exempt and in some of the highest-tax states they are exempt from local taxes as well," he says. "It's a greed factor as much as anything that leads people to this product. If they want to avoid paying taxes, they buy munis." Van Eck manages five muni bond exchange-traded funds (ETFs) holding $252 million in total assets.
It doesn't hurt that munis are easy to understand and support as a key source of financing for tangible public goods such as roads and schools, he adds. Investors "may also know they're pretty safe," he says, given that states and smaller entities have defaulted on less than half of 1% of all muni bonds within memory.
"All of the tax advantages, all of the investment advantages—the conservative, triple-A [rating] for general obligation bonds—were true all along, but somehow seeing the announcements on the Web page, the tombstone ads directly in the newspapers, made a difference," says Kopp.
Some Institutional Investors Complain The expanded outreach to individual investors serves a couple of different purposes. First, retail investors are typically willing to pay more than institutional investors for munis. An underwriter can mark up an issue by 0.10% to 0.15% by paying a slightly lower yield than institutional buyers would accept, says Tom Spalding, national portfolio manager of Nuveen Asset Management, the muni arm of Nuveen Investments, which manages $32 billion in municipal closed-end mutual funds.
Second, underwriters like the retail allocation because it allows them to presell a certain portion of an issue before it's opened to competitive bids from institutional buyers.
High subscription rates by retail investors have sparked complaints by some institutional buyers about being shut out of certain issues that they need to achieve their funds' investment objectives. In response, the Municipal Securities Rulemaking Board, the industry's self-regulating body, is trying to improve distribution to the marketplace by proposing rules on the priority of orders for new bond issues. What constitutes a retail order is now very loosely defined, but under the proposed changes, underwriters would be required to document an issuer's definition of a retail order and follow the issuer's wishes regarding retail order periods.
The shortage or total lack of supply left over for institutional buyers is a problem mainly for smaller deals that have a lot of appeal in states with particularly high income taxes, such as Arizona, says Spalding at Nuveen. "Arizona is not a high-issuance state. There's some local [government] issuance for basic infrastructure projects, but you don't see the big state deals that you see in New York and California," he says. That means a bond offering worth $10 million to $15 million could easily be absorbed by the retail market.
Nebraska is another state where retail demand is greater for tax-exempt bonds because only local governments issue bonds, not the state.
Retail Allocation Though not ideal, as long as issuers allocate no more than 50% of bonds to individual investors during the retail order period, Nuveen would be willing to accept that, says Spalding.
Delaware allocates 20% of its bond issues to retail investors, which the state defined at one point as those individuals seeking to buy no more than $50,000 worth of bonds, says Stephanie Scola, the state's director of bond finance. Last fall, when credit markets seized up, Delaware temporarily loosened its retail allocation, enabling individual investors to buy nearly half of a $236 million bond issue, she says.
Although retail investors have more than once bought up the entire inventory of bonds maturing 19 and 20 years ahead, leaving only shorter-dated bonds for institutional investors, Scola says she hasn't heard any complaints from institutional investors when that's occurred.
Retail investors would probably buy more bonds if they were available, but Delaware isn't planning another retail offering until at least the end of 2009. To take advantage of the federal economic stimulus program, Delaware will consider offering other kinds of issues, such as Build America Bonds, which aren't tax-exempt and aren't likely to appeal to the retail market, she says.
Although investors' appetite for risk has expanded since March. disciplined investors intent on sticking to a certain asset allocation will continue to look to tax-exempt munis for the fixed-income portion of their portfolios, says Spalding.
"As long as the Fed has said they will keep interest rates low, we'll continue to see money" move into limited-term funds, with an average maturity of three years, adds Spalding, if investors want a higher yield than money-market funds currently offer. "We've seen a lot of demand there."
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