Households Support Munis and Find Logic with Bond Insurance

Parsing the latest muni holder profile from financial account data tracked by the U.S. Federal Reserve, we can see that the individual household sector accounts for the largest holder cohort at 42.4% for Q2 2023, with fund vehicles approximating 27% ownership. Within this context, fund vehicles include mutual funds, money market funds, closed-end funds, and Exchange Traded Funds (ETFs). Thus, retail ownership of munis, either on an individual basis or through proxies, approaches 70% of aggregate holdings. By far, mutual funds comprise the largest component of the fund vehicle class, approximating 71% of all fund holdings and 19% of all holdings in Q2 2023. A closer look at trend data for mutual funds since the “Great Recession” reveals a gradual decline in municipal holdings as allocations into more efficient and less costly ETF’s moved higher. ETF muni holdings during Q2 2023 came in at just under 3% of total outstanding debt. What we can say with reasonable confidence is that retail buyer perception of economic conditions is a likely driver of investment preference, whether into individual securities or fund vehicles. Taking a more historical view of municipal bond ownership, we observe that individual households have held a consistent and outsized majority of all municipal security assets throughout the past 18 years.

Since 2005, there has been more notable volatility tied to the ownership data of fund vehicles and banks, but less so for insurance companies. Mutual fund flows react sharply to economic conditions, market technicals, monetary policy and actual and perceived market liquidity characteristics. We suspect that banks and insurance companies are more sensitive to changes in the corporate tax structure as well as to the value proposition of municipal securities, whereas individual preference for the muni tax-exemption tends to be less reactive to the types of federal marginal tax changes that we have seen. Bank investment patterns have also made strategic changes given evolving High Quality Liquid Assets (HQLA) policy shifts, yet banks have been responding to the less-than-friendly rate environment and an uncertain regulatory future. 

In our view, overall allocations into fund vehicles can be explained by the dislocation in the municipal bond insurance space as well as credit events surrounding a number of high-profile muni defaults such as Detroit and Puerto Rico. Prior to the 2008/2009 financial crisis, municipal bond insurance maintained a much wider reach backing almost 60% of the new-issue market from a larger pool of underwriters, most of which carrying triple-A ratings at the time. We continue to maintain that bond insurance makes for a valuable enhancement, but it should not be viewed as credit substitution and the existence of the insurance policy should not give rise to relaxed credit criteria and standards on underlying obligors. The effects of sub-prime exposure on a number of the insurers’ non-muni structured finance debt obligation wraps along with rating agency requirements to post additional capital resulted in successive downgrades and eventual ratings withdrawals for many insurers with terms such as rehabilitation, conservatorship and runoff becoming the vernacular. Presently, Assured Guaranty and Build America Mutual (BAM) are bond insurance of choice as they are the only providers underwriting new business, posting a 62.8% and a 37.2% market share respectively during the first six months of 2023. The unexpected pandemic-induced recession with all of the tax and revenue displacement brought on by the national economic suspension made bond insurance that much more relevant.

While the nominal use of bond insurance declined during the first half of 2023, the likely by-product of substantially lower aggregate muni volume, the overall penetration rate was 9% as issuers recognize the intrinsic value of the wrap offering enhanced liquidity and better capital market access for some, lower borrowing costs, and an offset to potential underlying credit diminution. Not only has the primary market been active, but secondary insurance coverage has also been accelerating as institutional investors desire to better insulate their portfolios from possible credit erosion, which at the very least could mitigate downgrade risk. We believe that current bond insurance trends are likely to continue through the balance of 2023 and into next year, with prospects for somewhat higher penetration rates, as state and local budgets and revenue enterprises may find it challenging to preserve currently strong credit conditions. The availability of fiscal stimulus through various Federal legislative acts has tapered off and slowing growth will be an issue for certain credits over others. Bondholder communications that have recently been made available by both Assured Guaranty and BAM describe sound underwriting standards and the availability of sufficient capital and claims-paying resources that backstop unconditional timely payment of principal and interest should an underlying obligor have insufficient funds to meet its debt requirements. Such capital adequacy should cover both short and long-term commitments and can be expected to mitigate the short and long-term economic and credit effects of a slowing economy. We note that each firm employs relatively conservative underwriting standards and each maintains a well-diversified insured portfolio, geographically and by sector, and a deep surveillance bench necessary to identify potential credit problems within their respective insured book of business. Each seeks those credit structures having tight legal covenants that tend to perform favorably during down-cycles and those sectors that have historically demonstrated minimal bondholder impairment. We observe that these companies have positioned themselves well following the 2008/2009 financial crisis and have learned some very valuable lessons. we believe that bond insurer ratings should be preserved as economic uncertainty persists. We further posit that Assured Guaranty and BAM possess a viable business model necessary to successfully capture additional respective market share.