By Chris H. Sieroty

LOS ANGELES (MNI) - Foreign investors continued to increase their holdings of U.S municipal securities by a larger percentage that any other investor group in the second quarter of the year as issuers began selling taxable, higher yielding Build America Bonds to fund infrastructure projects nationwide, according to a report by the Federal Reserve.

Holdings of long-term municipal securities by foreign investors rose $5.6 billion, or 14%, to $45.6 billion during the April-through-June period, the Federal Reserve said.

"This is clearly a BAB effect," Matt Fabian, managing director of Municipal Market Advisors in Wesport, Conn., told Market News International.

Build America Bonds were created under the federal stimulus program signed by President Barack Obama in February. One of the goals of the Build America initiative was to lower municipal borrowing costs by enticing investors who don't benefit from the traditional tax exemptions on state and local debt.

Governments sell taxable bonds for public-works projects and receive 35 percent interest payment rebates under the program, scheduled to expire Dec. 31, 2010

However, California's latest bond sale in October, which included $1.75 billion in BABs was met with a tepid response from foreign and institutional investors, according to the state treasurer's office.

"There was scant to no interest among foreign investors for the BABs offered during our latest sale," said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer.

"The interest came from insurance companies, hedge funds, pension funds and other purchasers of taxable debt."

Fabian said the "no foreign interest" argument was common, but added that many of these bonds have ultimately wound up in foreign hands, even if the initial distribution was to domestic accounts.

"The Federal Reserve flow of funds (report) shows that foreign ownership of munis increased in the second quarter, after having been almost unchanged for the previous three quarters. This again is due to the issuance of BABs, Fabian said.

"That being said," Fabian told MNI, "accounts were generally more concerned over California than over Build America Bonds because of the state's well documented troubles and the number of media headlines published over the weekend, including that headline (in The Guardian) about California being a 'failed state.'"

Overall, California's latest bond sale generated less interest than a similar sale in March, forcing state officials to raise the yield and reduce the size of the debt sale.

Dresslar said the state sold $4.138 billion in general obligation bonds, down from $4.5 billion it originally planned to sell. The state raised the yields offered on the debt, which included taxable and tax-exempt bonds and $1.75 billion in Build America Bonds, after few retail investors placed orders than in previous bond sales.

According to the Treasurer's office it raised yields on 20-year tax-exempt bonds to 5 percent on Oct. 8, when institutional investors bid on debt. On Oct. 6, when the state starting taking orders from retail investors the state had planned to offer those bonds at 4.66 percent, the Treasurer's office said.

In March, individual investors purchased 75 percent of the $4 billion in bonds offered. Bond yields were much higher then as the state paid an annualized tax-free yield of 5.85 percent on the 30-year-bond.

Phil Fischer, municipal strategist with Bank of America/Merrill Lynch in New York, said it was "bizzare" if there wasn't foreign interest in Build America Bonds offered by California. "It's a rare instrument that offers high yields for the investor," Fischer told MNI.

"I can't tell you directly who is buying BABs, but before this (economic) crisis began we had standing orders from financial institutions overseas. There has been a lot of interest from European banks, Not so much from the Middle East or Asia."

Gary Kishner, a spokesman for JP Morgan Chase in Los Angeles, agreed, saying there has been ongoing investor interest from Europe, but interest from the Middle East and Asia has yet to materialize.

"There may be foreign interest in California's Build America Bonds as foreign investors would not get the tax benefits from a traditional United States tax-exempt offering," Kishner said.

"International investors could look to participate in the offerings as they evaluate the relative value of California credit in comparison to other investments," he said.

** Market News International Los Angeles **