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Foreign buyers snapping up U.S. muni bonds, but risks exist for clients

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Foreign investors are increasing their ownership of U.S. municipal bonds, according to Fed data. But should advisers be recommending muni investments to clients?

Not everyone is impressed with the muni market, or the increased participation of foreign buyers.

“It’s a late-cycle behavior,” says David Haraway, a principal at Substantial Financial, a planning firm in Colorado Springs, Colorado.

At the end of 2016, foreigners owned $106.4 billion in U.S. muni debt, up 32% from the end of 2014, according to the Fed data.
“I view it as a trend,” says James “J.R.” Rieger, head of fixed income at S&P Dow Jones Indices. Although that may be the case, foreign holdings remain a small part of the $3.8 trillion-dollar muni market.

Rieger admits that foreigners are not significant buyers. “Not yet,” he adds.

But overall buying activity has resulted in better gains for munis than have been seen in some other parts of the bond market.

Amid the ups and downs of the bond markets, these funds attracted new investors.
April 19

Through March 24, the S&P National AMT-Free Municipal Bond Index had a total return for 2017 of 1.11% vs. 0.88% and 0.77% for the firm’s investment-grade corporate index and its 10-year Treasury index, respectively.

Rieger attributes the outperformance, in part, to supply and demand. Much of recent issuance, he says, has been to replace older, higher-yielding munis. State and local governments have “not really been introducing new supply,” he says.

Haraway, however, likens buying munis now to purchases of the nifty fifty stocks in the 1960s. He ticks off a list of states that have enormous budget problems and asks, “How would you loan money [to them] and expect a return?”

As for foreigners’ buying of U.S munis, Haraway says, “To me, it’s noise.”

Rieger acknowledges that some states have problems. In particular, he notes Illinois and New Jersey.

“The pension deficits are significant, and the market is not penalizing them dramatically yet for that shortcoming,” he says.

Even so, Rieger is upbeat about the muni market. “As an asset class, investment-grade munis have a shorter duration, higher quality and a fairly attractive yield,” he says.

Rieger also believes foreign buyers should continue to be attracted to U.S. municipal bonds.

“The low- rate environment has brought munis down, along with investment-grade corporates and Treasuries. But when a foreign investor is looking at diversification, the muni asset class becomes one of those tools,” he says.

And because the supply and demand imbalance is likely to continue, Reiger says “crossover” buyers from outside the U.S. could have help support better returns in the market.

Of course, he says there are numerous uncertainties that affect this and other markets.

“Rather than the influence of foreign buyers, the variable that I think is most important in the current market is whether there will be a substantial change in tax rates,” says John Frankola, president of Vista Investment Management in Pittsburgh. “If tax rates are lowered, it will make outstanding municipal bonds less attractive when compared to taxable securities.”

For advisers willing to live with that uncertainty, there are more than two dozen muni ETFs available, including investment-grade and high-yield, which hold bonds of short-, intermediate- or long-term maturities.

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