Foreign Buyers Shake Up U.S. Municipal Bonds by James Dearborn

U.S. investors who buy munis for tax-efficient stability are getting help from an unlikely source — investors abroad.

Over the past few years, foreign investors have been dipping their toes into the U.S. municipal bond market. It’s still a fairly small proportion of the overall investor base, but their presence is growing fast and it’s helping to drive some interesting changes in the market as a whole.

The muni market has traditionally been the realm of U.S. high-net-worth individuals looking to take advantage of the tax-exempt interest payments that munis offer. These people still make up the majority of the market, but there have been some important changes since the Build America Bonds program in 2009 and 2010.

Municipal bonds draw new investors in search of returns

That program was designed to encourage municipal issuers to raise debt for shovel-ready projects, and more than $181 billion worth of bonds were issued as a result. In the process, a lot of new investors were enticed into the market. Institutional buyers who had previously focused on corporate, investment-grade debt suddenly began to look at munis as an interesting asset class.

The same thing is now happening with foreign investors, particularly from Asia but also from Europe. With interest rates so low in many of these investors’ home markets — and in negative territory in places like Japan, Sweden and Switzerland — they are looking further afield for returns. They are already very familiar with U.S. Treasuries and corporate debt, but municipal bonds are often an entirely new area for them.

Foreign investment in muni bonds has skyrocketed

Municipal Bonds

We have seen this interest firsthand. We often spend time with potential overseas investors outlining the main aspects of municipal bonds, such as the difference between local general obligation bonds and revenue bonds, and the fact that these bonds aren’t guaranteed by the state or federal government.

A strong preference for quality

The lack of a guarantee isn’t necessarily a problem. After all, the historical default rate among municipal bonds is tiny, particularly when compared with corporate debts with similar ratings. Even so, the foreign investors we’ve talked to tend to have a definite preference for high-quality issuers and steer clear of speculative-grade securities. With time and growing familiarity, that might change and they may venture into some lower quality municipals, but it hasn’t happened yet.

Growing demand for taxable municipal bonds

In any case, their presence in the market could start to change things. Demand already outstrips supply in the muni market, which is why yields have been falling over the past year, and a lot of the increase in demand is coming from foreign investors. That could encourage more municipal issuers to come to the market, particularly with taxable securities. While U.S. investors prefer tax-exempt municipal bonds, these aren’t of particular interest to foreign investors as they don’t pay federal income tax. For issuers, though, there are far fewer regulatory issues to deal with when issuing a taxable bond compared with a tax-exempt bond, so it can be a more attractive option.

Bottom line

It is still early days for foreign investors, and it’s hard to know if the current trend will continue. But it seems likely that there will be a steady flow of investors’ money coming into the muni market for at least as long as interest rates remain negative or very low in some key markets around the world. That strikes us as a positive thing for a couple of reasons. First, the larger pool of investors could help to create a more active market. Second, and perhaps more importantly, the new supply and demand dynamics in the market should also help to support muni prices, which ought to benefit U.S. investors too.