In the current cold, barren, negative interest rate environment, foreign investors are getting hungry and desperate as they hunt for yield. In the hopes of kick-starting economic activity around the globe, central bankers are taking the drastic measure of establishing negative interest rate policies. This unusual endeavor is pressing international investors to chase yield, no matter how small, wherever they can find it.
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One of those areas in which foreigners are hunting for yield is the U.S. municipal bond market (see FT article). On the surface, this sounds ludicrous. Why would an outsider living in Germany or Japan invest in a U.S. municipal bond that yields a paltry rate that’s less than 1.7%, especially considering those investors will not benefit from the tax-free income advantages offered to Americans?
As strange as it sounds, Natalie Cohen, Wells Fargo’s head of municipal research correctly pointed out this pursuit for municipal bond yield across continents boils down to simple math. “Even if [foreign investors] are not subject to the US tax code, a plus two is better than a minus one,” Cohen notes.
Although foreign investment in the $3.7 trillion municipal bond market is relatively small, the rapidly rising appetite for munis is clearly evident, as shown in the chart below.
With our country’s crumbling roads and bridges, these ever-increasing piles of foreign cash pouring into our municipal bonds are helping fund a broad array of U.S. infrastructure projects. Given the election season is upon us, this issue may gain heightened attention. Both likely-presidential candidates are highlighting the need for infrastructure investment as part of their platforms, and the NIRP (negative interest rate policies) agenda of international central banks may make these municipal infrastructure dreams a reality.
We Americans are no stranger to the idea of borrowing money from foreigners. In fact, the Chinese own about $1.3 trillion of our Treasury bonds. This is all fine and dandy as long as the international appetite for lending us money remains healthy. If our city, state, and federal governments become too addicted to the Chinese, Europeans, and Japanese loans, financial risks can/will grow to unmanageable levels. Guess what happens once our borrowings swell to a level that forces foreigners to question our ability of repaying their debt? Interest rates will accelerate upwards, our interest payments will balloon, and our deficits will widen. The consequences of these unfavorable outcomes will be devastating budget cuts and/or tax increases.
For the time being, we will gladly accept the charitable donations of foreign investors to help lower funding costs for our sorely needed infrastructure projects. Fortunately, for now fiscal sanity is prevailing. The post financial crisis political environment has scared municipalities from borrowing too much, as explained here by the FT:
“For local and state politicians grappling with pension reforms, new healthcare programs and — in Alaska, Texas and Oklahoma — a drag on finances from lower energy prices, the looming presidential election is also diminishing the appeal of [municipal debt] issuance.”
In a near-zero/negative rate environment, there certainly will be incentives for irresponsible governments and corporations to extend themselves too far with cheap debt. However, in the short-run, as starving foreigners hunt for yield in the U.S. municipal bond market, Americans have the opportunity of exploiting this foreign generosity for the benefit our country’s long-term infrastructure.