Preferential capital treatment, low correlations, stable ratings, and ESG friendly credits, have renewed interest in the asset class.

Many white papers have explained US municipal bonds to institutional investors in recent years. This paper focuses on why taxable municipal bonds have attracted foreign institutional investors in particular, and why appetite for these bonds remains keen, despite rising currency hedging costs.

US retail investors have long dominated the US municipal bond market, but over the last decade, institutional interest in the sector has soared, particularly outside the US. So far, these non-traditional investors have been rewarded. Over the last 10 years, taxable US municipal bond returns have beaten all but one major bond sector, municipal high-yield (Figure 1). Consequently, the sector’s 6.9% annualized total return for the period handily outperformed the 4.6% return on US corporate investment-grade bonds, a staple in most institutional portfolios (see Figure 1). But strong returns are just one of many reasons that non-traditional investors have ventured into the asset class. Taxable municipal bonds are also garnering interest due to their high quality ratings, longer durations, inefficient pricing and low correlations and diversification to other asset classes.

New Interest in an Old Sector

Non-traditional appetite for US municipal bonds was whetted in 2009, when the Obama Administration created the Build America Bond (BAB) program to stimulate an economic recovery from the Great Recession. At the time, many states and cities were having difficulty tapping the traditional, taxexempt municipal bond market to fund capital projects. As a solution, BABs subsidized the interest cost on taxable municipal bonds to make them affordable to issuers and broaden their potential investor base. Over the two years the program was in effect, issuance of taxable municipal bonds surged from $24 billion in 2008 to $85 billion in 2009 and $152 billion in 2010. (; US Municipal Issuance)

Supply piqued demand. Non-traditional investors learned that taxable municipals offered an array of structural benefits and can offer incremental returns due to inefficient pricing in a fragmented market. Simply stated, what municipals lack in liquidity they make up for in higher yield spreads and total return potential. Diversification benefits and the possibility of lower capital charges have resulted in increased foreign demand of taxable municipals, as well as foreign ownership has more than doubled from $51 billion in 2008 to nearly $106 billion as of September 30, 2018. (Figure 2).

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