CSG: Some Interesting Patterns in the Fed Flow of Funds Data
By CSG Managing Partner, George Friedlander
On Thursday, September 20, the Federal Reserve published its flow of funds data for the second quarter of 2018. A few interesting patterns showed up on the Municipal Securities page:
• After dropping roughly $20 billion in the first quarter on very light new-issue supply, outstanding munis increased very slightly--$2 billion—as issuance improved and bond calls and maturities stayed pretty much on track.
• Holdings of municipal securities by the Household Sector dropped roughly $4 billion during the first half of 2018, but as we see it, direct retail holdings dropped more than that, on a continuing downward path. The difference was made up by an increase in holdings by separately managed accounts.
• Despite a far less favorable tax environment than before Tax Reform, Property and Casualty Insurers added $5.2 billion to muni holdings in the first half of 2018. This is actually a significant reversal from the downward trend in muni holdings during 2015-17, when P&C holdings declined by $18.9 billion over two years. Why the reversal? We suspect that much of it has to do with P&Cs’ ongoing quest for longer maturity, strongly secured assets, which remain difficult to find in the corporate bond market or in foreign securities
• Muni bond fund holdings increased by $8.6 billion, a far less rapid rate of increase than during 2017, when funds added $55.9 billion over the entire year.
• Also significantly, Commercial Bank holdings were down sharply for the second quarter in a row, off $10.9 billion in the second quarter after being off $15.8 billion during the first quarter. This pattern largely reflects the reduced tax benefit for holding munis, when taxable bonds are only taxed at 21% at the Federal level.
Implications of the Fed Patterns
We continue to expect that the changing patterns described above will affect the functioning of the muni market in a number of ways. These include:
• A smaller appetite for lower-coupon bonds, where commercial banks had made up a significant part of the aggregate demand. On competitive underwritings, in particular, the frequent need to use lower coupon bonds to win a deal is running directly up against weaker demand for this paper from banks. We suspect that over time, this pattern may make competitive underwritings less attractive relative to negotiated deals, as underwriter bid less aggressively on competitive issues that require heavy amounts of low-coupon paper.
• A larger proportion of total demand pushed inside 10 years, as separately managed accounts, that function almost exclusively inside that maturity range show stronger demand than bond funds, which tend to be significant marginal buyer of long paper. A key consequence of this pattern is likely to be a steepening of muni yield curves and the muni/treasury “ratio curve,” as longer paper becomes more difficult to place.