Ironically, if we want to understand how this proposed change might actually affect state and local governments, we should look to investors in other countries. Foreign investors matter to the municipal bond market for two reasons, one indirect and one direct.
Interest rates on U.S. Treasury bonds (or “Treasury yields”) have sat at record low levels for nearly five years. For this, we can mostly thank foreign investors. According to the Federal Reserve’s Flow of Funds statistics, as of the third quarter of 2012 a class of investors known (somewhat mysteriously) as the “Rest of the World” holds $5.5 trillion in U.S. Treasury bonds. That’s roughly 48 percent of all the $11.3 trillion in outstanding Treasuries, up from just over 30 percent of $3.6 trillion in 2002. Each time the Treasury has needed to borrow more money, foreign investors -- particularly from China and Japan, who currently hold about $1.1 trillion each -- have been happy to write the check.
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Treasury yields are a key benchmark for yields on municipal bonds. Predictably, municipal bonds have also sold at record low yields during this same period.Meanwhile, international investors have also snatched up mass quantities of municipal bonds. According to those same Flow of Funds numbers, the Rest of the World tripled its holdings of municipal bonds during the past six years, from $29 billion in 2005 to $91 billion in the third quarter of 2012. That $91 billion is almost 5 percent of all the municipal bonds not held by U.S. households. By some estimates this growth in direct foreign holdings, while still a small portion of the overall municipal market, has propped up demand for municipal bonds. The net effect for state and local governments has been billions of dollars saved through lower borrowing costs.
It’s counterintuitive that foreign investors -- most of whom don’t pay U.S. federal income taxes -- have become so intrigued with bonds whose main advantage is an exemption from federal income taxes. But it makes sense when we consider the outsized influence of the Build America Bonds (BABs) program. This now defunct program was designed to draw investors who don’t typically benefit from the tax exemption into the municipal market. The concept was simple: Instead of subsidizing tax-exempt bond investors, the U.S. Treasury paid a subsidy to states and municipalities that sold taxable bonds. BABs were tailor-made for foreign investors. They offered yields much higher than traditional municipal bonds, but with little to no additional credit risk. Not surprisingly, many foreign investors ramped up their municipal holdings in the form of BABs.
All this suggests that if the federal government tweaks the municipal bond tax exemption, one of the key questions going forward is: Will foreign investors continue their love affair with U.S. government debt? Some think not. As Bill Gross, co-founder of the enormous bond fund PIMCO, has said, foreign investors are buying U.S. government debt because we are the “cleanest dirty shirt” in the world. But this could change quickly. If the governments of Asian and European countries can address their own fiscal problems, investors in those countries might shift their money back home. U.S. interest rates would rise in response, and without the federal exemption, state and local governments could face much higher long-term borrowing costs.
On the other hand, the BABs experiment shows us that foreign investors will buy lots of municipal bonds if the circumstances are right. If municipal bonds become taxable in part or in whole, the circumstances might be more right than ever. Foreign investors might bolster demand and drive down yields. In that case, foreign investors can make losing some or all of the muni exemption a difficult but more manageable challenge for states and localities and the roads, bridges and schools they hope to build.
