* Households' share of market shrinks over 5 years
* Mutual funds continue to sweep up bonds
* Money market funds hold lower amounts
By Lisa Lambert
WASHINGTON, June 6 (Reuters) - The banking sector is becoming a greater force in the U.S. municipal bond market, with Federal Reserve data on Thursday showing that banks' holdings of municipal bonds reached a record $374.2 billion in the first quarter of 2013.
The sector now holds more than 10 percent of outstanding municipal bonds, nearly double its 5.9 percent market share in 2007, according to the Federal Reserve report.
In terms of institutional investors, banks hold the second largest amount of outstanding municipal bonds after mutual funds, in a market long dominated by individual investors. Households still hold the most outstanding bonds, but their market share has shrunk over the last five years, to 44.5 percent in the first quarter of 2013, from 49 percent in 2008.
Part of the reason for the banks' ascendancy is the increasing attractiveness of highly rated tax-exempt municipal bonds when compared to U.S. Treasury bonds, said Judy Wesalo Temel, principal and director of credit research at Samson Capital Advisors in New York. In the first quarter of the year, top-rated 10-year municipal bonds yielded on average 94.9 percent of similar Treasuries, which are taxed, Municipal Market Data shows.
"Banks will buy the high-quality municipals instead of Treasuries and they'll get the tax-exempt income," said Temel. "The other part could be that there are so many direct bank loans to issuers."
Issuers are selling bonds to the banks or directly borrowing more frequently, according to a recent white paper released by nine leading municipal bond organizations, often as a cheaper alternative to selling variable-rate bonds.
As a whole, the size of the municipal market grew slightly in the first quarter to $3.729 trillion from $3.714 trillion in the final quarter of 2012.
According to the Federal Reserve's report, households shed $16.8 billion of municipal bonds in the first quarter, considerably less than the $261.2 billion they dropped in the fourth quarter. Initially, the central bank reported in March that households shed $238.1 billion municipal bonds in the final quarter of 2012, which was a record amount.
The central bank adjusts the amounts of flows of funds for seasonal variations.
The smaller drop in the first quarter shows "an increased confidence in municipalities' finances," said MMD Analyst Domenic Vonella. He noted spreads between lower-rated debt and higher-rated debt tightened over the quarter, indicating investors became more comfortable with the credits.
Taxes also went up at the beginning of 2013, which would encourage households to hold onto tax-exempt bonds, he added.
The mutual fund sector continued to sweep up municipal bonds in the first quarter and the two may be related, said Temel, with individuals deciding to buy into funds instead of holding bonds directly. Mutual funds acquired $68.2 billion bonds in the first quarter, slightly more than the $67.4 billion they took on in the fourth quarter of 2012.
Money market funds, however, shed $83.5 billion in the quarter after acquiring $19.5 billion. Five years ago, money markets were the largest institutional holder of municipal bonds, owning $509.5 billion of the $3.517 trillion outstanding in 2008. In the first quarter, they held $312.6 billion.
As interest rates on the bonds fall, they have become less appealing to the funds. On Thursday, yields for top-rated 10-year bonds were 2.11 percent on MMD's benchmark scale for the secondary market, and highly rated 30-years yielded 3.28 percent. On the same day in 2008, top-shelf 10-years yielded 3.66 percent and 30-years 4.50 percent, according to MMD, a Thomson Reuters company.