June 5, 2014 / 4:06 PM / 5 years ago

Households pull back more from U.S. municipal market: Fed

WASHINGTON (Reuters) - Households backed away from U.S. municipal bonds at the fastest pace in more than a year in the first quarter, shunning a big rally in the largely tax-free asset and leaving them holding the smallest slice of the market in at least a decade.

Long the biggest investing force in the market, households cut their municipal bond holdings at a seasonally adjusted annual rate of $110.9 billion in the first three months of the year, according to Federal Reserve data released on Thursday. That was the most aggressive pullback by households, essentially individual investors, since the fourth quarter of 2012.

And with just $1.604 trillion of bonds at quarter’s end, households now own the smallest net amount of the debt since 2006, the Fed data shows. Moreover, it left them owning just 43.8 percent of the entire market, their smallest share since at least 2004 when the Fed adjusted its municipal data. At their peak ownership rate in late 2004, they held nearly 54 percent.

“With the interest rates going down further, they’re certainly engaging less in the market than they were,” said Peter Crawford, a senior vice president at Charles Schwab, about retail buyers.

Banks have stepped in to pick up some of the slack, holding $425.2 billion in the first quarter, the highest on records going back to the 1940s and 13 percent higher than the first quarter a year earlier, the Fed data shows.

The overall market also continued its contraction as state and local governments scaled back bond sales.

The total amount of municipal debt outstanding slipped to $3.66 trillion from $3.67 trillion at the end of 2013 to stand at the lowest since $3.61 trillion in the third quarter of 2009. That was before the short-lived Build America Bonds program inspired a burst of issuance.

Last year, interest-rate risk and headline scares from Puerto Rico and Detroit sent individual investors in the municipal markets rushing for the exits while state and local governments ended their long trend of refinancing. Bonds posted their first negative annual performance since the financial crisis and bond funds had the largest net outflows on record.

In early 2014 interest rates started falling, but supply remained low. The combination prompted a fierce hunt for yield, bringing many buyers to the municipal market, including hedge funds, but individuals were not major participants.

They missed out on the market’s strongest quarterly performance since the third quarter of 2011, with the Barclays U.S. Municipal Bond Index .BCMUN delivering a total return of 3.35 percent in the first quarter.

While individuals reduced their direct holdings of municipal debt, the municipal mutual funds preferred by retail investors saw a slight uptick, to $621.1 billion from $613.9 billion in the final quarter of the year. Still, that was down from $646.6 billion in the first quarter of 2013.

Reporting By Lisa Lambert; Editing by Dan Burns and Chizu Nomiyama

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