Economic Drivers Of AI And The Municipal Bond Market

Presenting on the “AI and the Municipal Bond Market” panel for the Council of Development Finance Agencies/BNY Mellon webcast series, I was asked why the market’s adoption of technology is now coming at such a blistering speed. After all, for years if not decades, the market had been resistant to technology or any sort of change, enjoying its status as boring, stodgy, clubby, and dull. Now the pace of technological change is stunning—with no signs of abating. If anything, it’s increasing.

Certainly there are many reasons for this remarkable pivot. Technology across the board is better and faster. Advances in AI, faster chips, more code, better connectivity, data science breakthroughs, market professionals who grew up with laptops and cell phones—each building on the other. The market is experiencing a variant of Moore’s Law on steroids. To add fuel to the fire, there is FOMO: fear of missing out. If your competitor has bigger, faster, better technology than you do, you risk falling hopelessly behind.

All valid and reasonable explanations, but not really getting to the core of answering the question.

Getting to the Core

On Slide 11 of my CDFA presentation (you can find this and the entire panels’ presentations on the CDFA website), I got to the core. Stripped down to its essentials, the municipal bond market is governed predominantly by investor cash inflows and outflows. Inflows and outflows drive rates, spreads, yield curves and all that goes with that. Do the statistical analysis and you find it is causal, not simply correlated.

Correspondingly, to fully grasp the implications of this, it is critical to understand where inflows are coming from and going to.

The municipal bond market is dominated by individual investors and their institutional proxies, the “Big 3” of the latter being Separately Managed Accounts, Mutual Funds, and more recently, Exchange Traded Funds.

As the slide shows, among these three, there is a distinct shift in where investors are putting their money.

It used to be open-end mutual funds dominated the market. From 2014 to 2022, these funds enjoyed a 30% growth in assets under management (AUM) from both net inflows and appreciation, eventually comprising 22.35% of all $4 trillion municipal bond market assets. Whatever money came into or left these funds ultimately set prices, spreads, and curves for the rest of the market.

That year proved to be a high-water mark for the funds.

Double Punch

Then a double-punch. The Covid-19 pandemic and Federal Reserve’s rate increases caused share price volatility and negative returns. Investors reacted swiftly, pulling billions of dollars out of the funds.

It was understandable. For many investors, large and small alike, municipal bonds are “mattress money”. In case the world goes to hell in a handbasket, municipal bond holdings are the safe reserve. High net worth investors don’t want and can’t have their “safe money” exposed to a panicky market whims.

Hence the move to separately managed account managers. Under professional management, guided by an investment mandate specific to their needs, investors view SMAs as the way to get both bespoke portfolios and limit if not avoid general market gyrations.

[Quick aside: Note that the $495 billion SMA AUM figure reported here were voluntarily disclosed by request to asset-trackers Morningstar and Cerulli & Associates. Screening numbers directly from SEC ADV filings required of every registered investment advisor, ADVDB put the total of municipal bond SMA assets at roughly double that, even after accounting for possible duplication by counting subadvisors.]

Additionally, the poor performance of actively managed funds brought doubt as to how effective active management really was if investors were getting their assets handed to them. Why pay fees to a fund manager who exposed you to risk and underperformed the market? Plus, fund management fees come out of tax-exempt income. During a low rate environment, that is expensive money.

This put registered investment advisors (RIA), either independent or at broker/dealers, in a bind. Municipal bond mutual funds had been an easy go-to investment vehicle for clients wanting tax-exempt income and safety. No more.

But unfamiliar with the municipal bond market’s eccentricities and lacking the SMA operational infrastructure, advisors were reluctant to put clients into individual bonds.

There was an emerging alternative. Indexed exchange traded funds (EFT) such as the iShares National Muni Bond (NYSE: MUB) with low expense ratios (usually less than 1/10^th of one percent), made total sense for many of their clients. Tracking a market index, well diversified, more liquid than a traditional mutual funds since valuation was ongoing, not once at the end of the day, they proved an attractive solution. The $40 billion growth in ETF AUM from 2021 to 2023 stands as testimony to that.

The trends for 2024 show more of the same.

The market implications of this shift away from funds and into ETFs and SMAs continue to reverberate. In particular, since ETFs and SMAs manage their assets very differently than an open-end mutual fund—an ETFs buys index qualified larger block sizes ($1 million +) and SMAs traffic in odd-lot blocks (under $100,000)—the effects on pricing and trading patterns in those market segments has been pronounced.

All well and interesting, but what does any of this have to do with AI and technology?

A Second Look

Look at the slide again.

The aggregate concentration of $1,463 billion of assets among the top 10 managers of each of these individual investor surrogates comprises nearly 35% of the total municipal bond market.

While the effect on the broader market is not to be ignored, for the zaftig-asseted money manager, the immediate business takeaway is that they are locked in a hyper competitive battle for asset growth, performance, fees, and ultimately, earnings.

Correspondingly, every dollar and every basis point counts. So any technology automating a process—operations, portfolio management, trading, analysis, recordkeeping, compliance—making it go faster, executing more efficiently, offering any edge either making or saving money, is going to be fully explored and developed.

And here is AI, economical and evolving at breakneck speed, offering solutions for all the above that were unthinkable only a handful of years earlier. It is no wonder asset managers are recruiting data scientists and software engineers with Ph.Ds over the mere finance-focused MBA.

They know the one thing that remains consistently true:

Technology wins.

This article is the fourth in a series on AI in the Municipal Bond Market. The next article covers the problem of pricing bonds in the municipal bond market.