Foreign investment in the U.S. municipal bond market has exploded in the last 10 years.

From 2001 through the second quarter of 2012 foreign investors increased their holdings of munis by more than 11-fold. While foreign investors owned $8 billion at the end of 2001, they had increased their ownership to $89 billion at the end of the second quarter of 2012, according to the U.S. Federal Reserve.

The Fed estimates the total size of the market at $3.7 trillion, with most owned by the domestic “household sector,” with $1.8 trillion. Other major holders include mutual and money market funds, banks, and property and casualty insurers.

Foreign ownership still only accounts for about 2.4% of the total market but by comparison, municipal bond exchange-traded funds had just $11 billion of muni holdings at the end of of the second quarter of 2012.

Though muni ETFs have also been rapidly expanding since their introduction in 2007, at the end of the second quarter of 2012 they held only 0.28% of outstanding municipal debt.

While foreign holding of Treasuries went up by 4.3 times from 2001 to 2011, foreign holding of munis went up by 10.3 times in the same period. Yet at the end of 2011 foreign investors’ holding of U.S. munis was just 1.8% their holding of Treasuries.

Several factors have led to the increase in foreign ownership of municipals.

Foreign purchasers of munis are more interested in taxable munis than tax-exempts because of their higher yields, several muni analysts said. “As municipalities started to issue more taxable bonds, this started to attract additional investors,” said Alan Schankel, managing director of fixed-income research at Janney Montgomery Scott LLC.

Foreign interest in munis was stoked in 2003 when what was then the largest taxable muni issue in history, a $10 billion Illinois pension bond offering, came to the market, according to UBS municipal bond strategist Kathleen McNamara.

International Basel II standards for banks were published in June 2004. These gave U.S. municipal bond ratings a favorable risk weighting and led European banks to buy U.S. munis, said Ken Friedrich, manager of muni sales, trading and syndication at RBC Capital Markets.

Foreign interest in purchasing munis got a big boost with the Build America Bond program in 2009 and 2010, several analysts said. For BABs, the federal government promised to pay a portion of the interest on taxable municipal bonds.

The BAB program resulted in taxable municipal bond issuance leaping from $24.2 billion in 2008 to $84.6 billion in 2009 and to $151.9 billion in 2010.

Several large firms marketed BABs outside the U.S., noted Michael Decker, managing director of the Securities Industry and Financial Markets Association.

In March 2010 California sold $3.4 billion in taxable bonds, of which $2.5 billion were BABs. Of the $3.4 billion, half of the orders came from foreign investors, according to California treasurer spokesman Tom Dresslar.

Citi set up municipal sales desks in foreign offices in 2000. It told The Bond Buyer in 2010 that about 15% of their BAB offerings were sold abroad.

Despite the end of the BAB program in 2010, foreign purchasing of munis has proceeded at nearly the same level. Foreign flows into munis peaked at $13.1 billion in 2010, according to the Federal Reserve. That number slipped to $10.9 billion in 2011. On an annualized basis, they were $12 billion in the first quarter of 2012 and $12.8 billion in the second quarter, just 2% lower than in 2010.

In 2008 the ratio of muni to Treasury yields soared and that attracted foreign investors to buy munis, McNamara said. While the ratio of muni yields to Treasury yields slipped to historically average levels in 2009 and early 2010, they have generally been high since then, McNamara noted. At the end of Tuesday the ratio of the triple-A 10 year general obligation municipal bond to the 10-year Treasury was 105.4%, compared to a 10-year average of 90.8%, according to the Municipal Market Monitor.

Bank of America Merrill Lynch manager of muni research John Hallacy noted that economic problems in the euro zone have led global investors to seek U.S. dollar-denominated assets. Since many foreign investors view munis as an alternative to Treasuries, perhaps it was a natural development that when foreign investors poured money into Treasuries from 2008 to the present, some of the same investors would consider investing in munis as well, Hallacy said.

While those are some of the short-term factors that have contributed to foreign investors increasing their purchase of munis since 2001, there have been other, more persistent factors.

Hallacy said foreign investors like munis because they are a safe asset and allow diversification of holdings.

“Global investors are looking across the world for different investment opportunities,” McNamara said.

Because foreign investors do not pay U.S. taxes they don’t benefit from the tax exemption typically provided by the U.S. tax code to municipal bonds. Accordingly, they are usually attracted to the higher yields paid by taxable munis.

While most agree that foreign investors are mainly interested in taxable munis, Citi municipal strategist Vikram Rai said they consider purchasing tax-exempt munis.

Foreign buyers like “big name” muni issuers like California and New York City, Hallacy said. That is partly because of the superior liquidity accorded to the bigger names in a market that is far less liquid than the Treasury bond market.

Citi focused on selling bonds from big issuers like Illinois and California to foreign investors in the BAB era, according to Reuters. This was because it was most cost-effective to sell abroad deals totaling more than $250 million, Citigroup director of U.S. municipal strategy Patrick Brett told Reuters.

Foreign buyers are interested in zero-coupon bonds and school capital-appreciation bonds for their high yield, Rai said.

Muni market observers said there are five main foreign purchasers of U.S. municipals: banks and central banks, insurance companies, pension funds, hedge funds and mutual funds, such as sovereign wealth funds and international bond funds. Most observers said there were few individual purchasers.

Many of the foreign investors hail from Europe, Hallacy and McNamara noted. Some muni observers also mentioned Asia, and in particular Hong Kong and Japan.

California’s March 2010 BABs sale had purchasers from 16 countries, Dresslar said. While foreign purchasers are mostly from Europe and Asia, Hallacy said they are from all over the globe.

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