Don’t Blame ETFs For Poor Muni Liquidity

January 07, 2016

Most municipal market investors and their advisors would agree that liquidity in the municipal bond market has declined in the last several years.

Even as liquidity has declined, however, the municipal bond market has continued to grow and attract investors. According to data from the Federal Reserve, in the first three quarters of 2015, total market size increased by $57 billion (to $3.7 trillion) and direct household ownership of municipal bonds increased by $8.8 billion. Indirect ownership through mutual funds increased by $29.8 billion. According to FactSet Research Systems, over the same time period, total assets in muni bond ETFs grew by $3.6 billion, to an estimated $22.0 billion.

Some participants in the traditional over-the-counter municipal bond market have been wondering if the growing popularity of municipal bond ETFs has been draining liquidity from the market for individual bonds.

An analysis of municipal bond ETF flows suggests that rather than draining liquidity from the municipal bond market, muni ETFs (the first of which came to market in 2007), have in fact attracted new liquidity to the marketplace.

Historical Demand

Because of the lower interests rates earned when compared with comparably rated taxable bonds, municipal bonds have historically been most appealing to individual investors in the upper Federal income tax brackets. (The higher the tax rate, the greater the benefit of the tax exemption on the income earned.) Because of this, ownership of municipal bonds has been dominated by households.

Direct ownership (via portfolios of individual bonds) accounts for more than 40% of the market. When combined with indirect ownership through mutual funds, closed-end funds and ETFs (presumed to be primarily from individual investors), household ownership represents almost two-thirds of the market.

Trading Activity

At $3.7 trillion, the market is large, but it is also very complex. With more than 60,000 issuers and well over 1 million CUSIPs, it is the complexity of the municipal bond market that has made it difficult to attract significant participation by hedgers, traders and active (tactical) asset allocators.

Additionally, even though the municipal market includes several electronic trading platforms, the overall market is not centralized on an exchange, so trading liquidity is supported by the more than 1,500 registered dealers located around the country. (The number of dealers has declined 22% since 2009.)

Municipal bond trading activity has long been dominated by customer-related transactions. Through October of last year, 45% of municipal bond market trading activity was customer buying (which includes household purchases as well as investing by institutions such as insurance companies and funds); customer selling was an additional 23% of total volume. (The balance consisted of trading between dealers.)

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