U.S. households hold the least municipal debt since 2008, and are instead stockpiling the most cash in at least four years, offering a cushion for the $3.7 trillion market as yields reach an 11-month high.
Individuals buying local debt directly through brokers, instead of using vehicles such as mutual funds, cut municipal assets to $1.68 trillion at year-end, Federal Reserve data show. While that’s still the single biggest chunk of the local market, it’s the lowest since March 2008. Holdings fell as local yields dropped in 2012 to levels unseen since the 1960s.
With the U.S. jobless rate at a four-year low and the Dow Jones Industrial Average setting a record high, 10-year Treasury yields will rise about a half-percentage point to 2.5 percent in a year, according to the median forecast of 61 analysts in a Bloomberg survey. An increase of that size will draw investors back to tax-exempt borrowings, said George Friedlander, head of muni research at Citigroup Inc. in New York.
The cash pile “provides a real cushion for the municipal market, specifically in a rising-rate environment,” said Friedlander. “Any significant increase in yields, and you will get a bounce in direct retail demand.”
Even as the Fed keeps its benchmark rate near zero, where it has been since 2008, money in foreign deposits, checking and savings accounts and money-market funds tallied $10 trillion at the end of 2012, the most since at least 2008, Fed data show.
“There is this massive pool of uninvested retail-investor funds which will support the municipal market at some point, if rates go back up,” said Friedlander, whose firm is the third-biggest U.S. bank by assets.
Buyers started shying away from tax-exempts in December as yields fell to 47-year lows. Treasuries led a fixed-income rally last year as investors sought a haven from global credit concerns. Both markets have lost money this month, with munis declining 0.7 percent and Treasuries 0.6 percent, Bank of America Merrill Lynch data show.
Yields on 10-year benchmark munis rose to 2.07 percent yesterday, the highest since April, Bloomberg Valuation data show. Benchmark Treasury notes maturing in 2023 yielded about 2.02 percent.
The tax-exempt benefit of munis will help the securities compete against federal debt, corporate bonds and other fixed-income securities, Mark Maroney, global head of munis and securitized products at RBC Capital Markets LLC in New York, said in an interview.
Increased tax rates provide another incentive for individual investors. For those in the highest tax bracket, 39.6 percent, the benchmark 10-year muni yield equals 3.43 percent on a taxable basis, Bloomberg data show.
“In a rising rate environment, it will be munis that will rebound quicker as assets start to make their way back to fixed-income product,” Maroney said.
Combined muni holdings of investors subject to individual tax rates, or households, mutual funds and money-market funds accounted for 71.2 percent of the tax-exempt market in 2012, down from 74.5 percent in 2008, Peter DeGroot, an analyst at JPMorgan Chase & Co. in New York, wrote in a March 8 report.
“Retail investors do engage more aggressively in the municipal-bond market at higher yield levels,” he said in an interview. “Should rates rise materially in the future, that would be additive to demand from the retail sector of the market.”
About 77 percent of U.S. households face higher taxes after Congress in January ended a payroll tax cut and boosted income-tax rates on households earning $450,000 or more to 39.6 percent from 35 percent, according to the nonpartisan Tax Policy Center in Washington.
The higher the tax rate, the more individuals will seek munis for their exempt status, DeGroot said.
“Increases in taxes at the federal level, as well as state and local level, will definitely over time increase the proportional ownership of municipal securities by investors who are subject to those individual tax rates,” DeGroot said.