Muni Bonds: Why States Are Chasing Retail Investors

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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."

Bogoslaw is a reporter for BusinessWeek's Investing channel.

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