The municipal market grew in the third quarter of 2024 amid the surge in supply while mutual funds, exchange-traded funds and foreign buyers increased their ownership of the asset class in the third quarter, Fed data shows.
However, “muni holdings of all institutional investors, lead by banks, is still down substantially and we do not see that changing to a large degree next year,” Barclays strategists noted in a weekly report.
Bank ownership of munis fell to $497.2 billion, down 0.3% from the second quarter of this year and a decrease of 4.3% from Q3 2023 and brokers and dealer muni holdings fell the most quarter-over-quarter, declining by 10.5% to $16.2 billion, according to the latest Federal Reserve data.
Most of the decrease in banks’ muni holdings is “attributable to deposit outflows (for smaller and medium-sized banks) and regulatory challenges in the past several years,” according to a Wells Fargo strategists in a 2025 outlook presentation.
“This is because a reduced deposit base for regional banks led to a shrinking of their balance sheets and thus reduced demand for assets, including municipal assets (high-grade, long-duration, high-coupon paper),” they said. “Meanwhile, in theory, the deposit base for larger banks should increase after this turmoil but so far it did not lead a commensurate increase in aggregate balance sheet for larger banks given that the size (of balance sheets) remains under scrutiny.”
However, Wells Fargo’s strategists noted that “deregulation should benefit banks and reduce capital scarcity and constraints on the size of balance sheets,” helping drive demand for high-quality debt, including munis.
The face amount of munis outstanding rose to $4.171 trillion, a 0.8% increase from Q2 2024 and 2.9% from Q3 2023, according to the latest Fed data.
The market value of munis was at $4.152 trillion, increasing 2.8% from the second quarter of this year and 9.8% from Q3 2023.
Household ownership of individual bonds was the largest category of muni ownership at 44.8%, mutual funds at 19.5%, exchange-traded funds at 3.2% and U.S. banks at 12%. Life insurance companies own 4.4% and property and casualty insurers at 5.2%. Foreign ownership of munis is at $121.5 billion, up 2.6% from Q2 2024 and 12.3% from Q3 2023.
Household ownership of munis — which includes direct ownership of individual bonds in brokerage accounts, fee-based advisory accounts and separately managed accounts — surged to $1.86 trillion, up 3.4% from Q2 2024 and 15.1% in Q3 2023.
The sharp rise can mostly be attributed to the growth of SMAs, which hold $1.63 trillion of munis, according to Bloomberg data.
Mutual funds increased to $810.9 billion in Q3 2024, rising 4% from Q2 2024 and 11.4% from Q3 2023.
ETFs surged to $133.3 billion, up 7.2% from Q2 2024 and a whopping 23.4% from Q3 2023.
“This year’s fund flow activity indicates a committed buyer of both ETF and open-end funds,” said Kim Olsan, senior fixed income portfolio manager at NewSquare Capital.
Unlike last year when ETF flows ended positive but mutual funds lost assets, this year’s activity shows double the volume has been put into national mutual funds as compared to ETFs, she said.
Since 2019, $105 billion has been allocated to muni ETF strategies or $24 billion more than mutual funds, Olsan said.
“Growth in the ETF sector with various program initiatives has been impressive,” she noted, which can be attributed to several factors.
For one, trading costs are paid more attention than fund management fees in the muni market, Wells Fargo strategists said.
“ETFs, especially those that have grown to scale, show lower transaction costs than cash bonds,” they said. “Nearly all ETFs trade more attractively than wider bid-ask spreads expected in odd lots trading.”
Additionally,
“Index selection is essentially an active process … and municipal ETF flows have been skewed toward core index products,” they said.
Investors are more comfortable with passive ETFs in the absence of credit stress in muni markets, and ETF passive returns are keeping up with actively managed products, according to Wells Fargo strategists.
“That said, we are unlikely to witness the kind of growth witnessed in 2022-2023 given the lack of tax-loss harvesting (where investors sell their mutual fund holdings but maintain exposure to municipals via ETFs to avoid tripping on the wash-sale rule) and the competition from equities,” they said.