Who Is Buying Municipal Bonds?

Interest rates are rising in the U.S., but remain well below an area that's considered historically average. In other major developed markets, benchmark borrowing costs are at or near record lows, or in some cases, negative.

That is to say investors in ex-U.S. developed markets are looking for income and they're looking to some U.S. bonds to provide that income. A popular destination has been low-risk U.S. municipal bonds, although the iShares National Muni Bond ETF MUB, the largest municipal bond exchange traded fund, has lost $381.4 million in assets this year.

There are valid reasons for foreign investors embracing U.S. municipal bonds, including a "strong U.S. dollar or perspectives of a strong for longer U.S. dollar,” S&P Dow Jones Indices said. “U.S. municipal bonds, whether tax-free or taxable, offer incremental yield relative to the negative or near zero yield environments seen in the Eurozone and Japan. The relatively high quality of investment grade municipal bonds to other asset classes such as U.S. corporate bonds and in some cases sovereign bonds.”

See Also: An Income ETF That Lowers Rate Risk

MUB has $7.8 billion in assets under management, so its year-to-date outflows are small relative to its overall size. Underscoring the point that investors want yield, the VanEck Vectors High-Yield Municipal Index ETF HYD has seen new money come into it this year.

HYD has a 30-day SEC yield of 4.4 percent, which is high among municipal ETFs. The ETF has an effective duration of 7.5 years. HYD allocates over 28 percent of its weight to California and Illinois munis, indicating that investors who have allocated more than $87 million to the ETF this year are comfortable embracing the potentially significant public pension risk that those two states bring to the table.

“Foreign holdings of debt issued by U.S. states and local governments rose 16% in the last quarter of 2016, reaching a record level of $106.4 billion,” VanEck said in a note out earlier this month. “While foreign ownership represents just a small fraction of the $3.8 trillion U.S. municipal bond market, it is a growing segment that has risen steadily since 2000. In the past two years alone, foreign ownership of muni bonds has increased 32%, from $80.6 billion at the end of 2014 to its present $106.4 billion.”