Foreign investors' holdings of United States municipal bonds rose to a record at midyear.
Foreign investors owned $77.4 billion of U.S. municipal bonds at midyear, up from $73.5 billion in June 2013, and the highest amount in the Federal Reserve flow of funds data released Thursday.
This data defies many analysts' and investors' assumption that foreign investors would exit the U.S. muni space after the federally subsidized Build America Bond program was terminated in 2010.
These investors' growing presence has heightened significance in the current low-supply high-demand market environment, in which an emerging group of buyers could cause competition for the limited amount of bonds available to spike.
"There still is a juncture of too little supply verses too much demand, and domestic investors are not necessarily going to be crowded out, but they will be forever competing with foreign purchasers for a confined amount of bonds available," Dan Heckman, senior fixed income strategist at U.S. Bank, said in an interview.
Foreign investors became active in the U.S. municipal bond space when the BAB program started up in 2009. That year they increased their municipal bond holdings by more than $20 billion, according to Citigroup report this month.
Anthony Valeri, financial analyst at LPL Financial said in an interview Wednesday that foreign investors may express some interest in BABs trading in the secondary, but won't get involved in tax exempt munis.
Foreign investors' U.S. muni holdings for the first half of the year have increased by 8% this year from holdings at the end of 2010, however, the year the BAB program was terminated.
"A lot of people were saying when [the Build America Bond program] was terminated in 2010 foreign would get out of the product because there was no more supply, but they continue to participate in large taxable deals coming to market," Mikhail Foux, director of credit, derivatives and muni strategy at Citi and one of the report's authors, said in an interview.
He said foreign investors have participated in many large taxable municipal deals that have come to market that are $250 million and up. The report said Citi anticipates foreign investors will start entering the tax-exempt space in the future.
Lured by Interest Rates
Foreign investors are increasing their overall U.S. municipal bond holding and may start investing in tax-exempt munis because U.S. interest rates are attractive to them, analysts said.
Heckman said he could see investors entering the U.S. muni space from countries including Japan and Germany, where interest rates are lower. The benchmark interest rate in Germany was last recorded at 0.05 percent. The benchmark interest rate in Japan was last recorded at 0 percent.
"There are quite a few developed countries around the world that have interest rates around or below ours," he said. "Some of our muni bond issuers have stronger credit profiles than foreign counterparts. Consequently when you combine all those different attributes it makes muni bond debt very attractive, even if you can't take advantage of tax exempt status."
Foux said that foreigners like to buy high quality names, and 80% of munis are investment grade, and 50% are double- A or higher.
"If you start looking globally where interest rates are, there are a few opportunities out there to buy triple-A bonds at high enough yields," he said. "That's the argument that foreigners -- given where the European sovereign yields are, when you compare those to U.S. muni yields -- they will go after Treasuries as the first stop, and then you can make the argument some U.S. municipalities have better credit than the country."
Many sovereign and quasi-sovereign bonds are actually trading at lower yields compared with U.S. fixed income products, including municipals, according to the report.
Low Volume, Cheap Costs
Foux said foreign investors are interested in tax-exempt municipal bonds at this time because taxable municipal volume was down this year.
Taxable issuance has fallen 40% this year, totaling $17.1 billion as of Aug. 31, according to data provided by The Bond Buyer.
He said foreign interest in munis also spiked because investors could get municipal bonds for low prices at the start of the year.
"The main reason foreign investors started buying municipal bonds at the start of the year was munis actually were quite cheap, they probably were buying mostly tax exempt because at the time they were opportunistic and buying taxable bonds was not as attractive," he said. "At the start of the year tax-exempt munis were cheap to Treasuries.
Impact on Buy Side
Investors agreed with Heckman's statement that a boom of foreign investors, or more investors in general, would be problematic for domestic buyers. A trader in Chicago said that in the short term, it would intensify the low supply high demand issues the market was already having.
"What we're seeing this year where is compression in yields based on credit, and very little differentiation between sectors, foreign buyers will exacerbate those situations," a trader in California said.
The trader in Chicago did say in the long term more buyers could be beneficial.
"It would certainly be helpful to municipalities to have more dollars for more projects," he said.
Foux said that more investors are important to the market in times of stress.
"One of the bigger and more important forces in terms of stress are crossover buyers, including foreign investors," he said. "Last year these buyers were one of the main contributors to the stabilization of muni market, and they will be a larger force going forward."
Ashton Goodfield, Head of Municipal Bond Trading for Deutsche Asset & Wealth Management, was more skeptical of foreign buyers' impact on the US municipal bond market.
"In a significant market downturn, you need any buyers you can get, but the foreign buyers are still not going to make a significant impact on market," she said in an interview. "Foreign buyers would need to buy a significant amount to have an impact, because the amount outstanding is $3.7 trillion."
Foreigners Attracted to Higher Rates
Foux said foreign investment in tax exempt munis probably would jump if there is a rate increase.
"The termination of [quantitative easing] and fact the Fed will start tightening at some point next year could push yields higher," he said. "And muni yields are correlated with Treasuries. So if Treasuries move higher munis move higher, and that could bring more interest from foreign investors and macro investors in general, if foreign rates remain low."
In the Federal Open Market Committee Forecast on Wednesday said the Fed it will hold interest rates at a zero to 0.25% range for a "considerable time."
