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Mom and Pop buy cum muni bonds directly as ETFs heat up

(Bloomberg) — Mom and pop investors have long been the main retail buyers of state and local loans. Now that is changing as fewer and fewer are directly buying municipal bonds on the $4 trillion market.

The value of bonds directly owned by households fell by $18 billion in the fourth quarter of 2021, the lowest level since 2008, according to Federal Reserve data. Instead, those buyers are turning to mutual funds and exchange-traded funds, which have nearly doubled their muni holdings over the past decade.

Managed accounts provide buyers with greater liquidity and diversification, and their rise has put a spotlight on fund flow data as a key bellwether of market health. It has homogenized the market by consolidating the investment strategies of individuals in the hands of benchmark-beating account managers.

“When individual investors were the drivers of the market, every investor is different and you have this incredible diversity of buyers and sellers,” said Patrick Luby, municipal strategist at CreditSights. “Munis will maintain their appeal to individual investors, but I think the way they access munis will continue to change.”

Together, the direct and indirect retail accounts for about three-quarters of the total value of the muni market, dwarfing the holdings of insurance companies and US banks, which each held about 12% in the fourth quarter.

Luby said that with interest rates falling over the past few decades, the risk and reward tradeoffs of buying individual bonds have shifted. Investors still took the risk of losing principal, but the small return made mistakes more costly. It also makes it harder for financial advisors to educate investors about individual deals to squeeze in profits.

Investors may not necessarily be selling individual bonds, but as their bonds mature, they are not putting as much money into new bonds. Federal Reserve data is not a perfect measure because it estimates households, or total market size, by subtracting all other reported holdings. Nevertheless, it is one of the closest estimates of how many muni loans individuals hold straight away.

“Mutual funds keep getting bigger, doubling their holdings significantly over the past decade,” said Mikhail Fox, head of municipal strategy at Barclays plc. “Right now, they are the most important institutional player in the municipal sector.”

Fox expects the reallocation of retail Muni Holdings to continue, and pointed to a similar trajectory in the corporate market.

Shweta Singh, Portfolio Manager, Citi Different Holdings LP, said, “There has been a lot of M&A activity in the mutual fund business and acquisition of separately managed ledger outlets. “Our market is becoming more focused with the big players, as there is bottom line pressure on margins.”

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