Local Government New Zealand's funding body is closely monitoring investment in its bonds as US Treasury yields increase, with concerns borrowing costs may rise if foreign investment demand drops off.

The Local Government Funding Agency (LGFA) is the second-largest issuer of debt securities in New Zealand behind central government. At LGNZ's quarterly media briefing in Wellington today, LGFA chief executive Mark Butcher said yield forecasts show government bond yields are expected to be lower than US Treasury yields for terms out to nine years. The yield on New Zealand's 10-year government bond was recently at 2.96 percent, up from 2.75 percent at the end of 2017, while US 10-year Treasuries are at 2.84 percent, having climbed from 2.41 percent.

LGFA expects offshore interest rates to keep increasing, while New Zealand's Reserve Bank has signalled it won't move for at least another year. Some 40.5 percent of LGFA bonds were held by offshore investors as at February 28, up 4.5 percentage points in the quarter, with bank holdings down 4.9 percentage points to 35.6 percent, domestic institutional holders down 0.2 percentage points to 25 percent and domestic retail holders up 0.6 percentage points to 3.9 percent.

"It does have implications for New Zealand, because we are a nation of borrowers as opposed to savers, and we do rely on offshore investors," Butcher said. "We're looking to see whether offshore investors are going to remain invested in New Zealand going forward, when you're no longer getting an attractive yield or return. We think that this disadvantage for New Zealand will continue for some time."

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Government data today showed foreign investment in New Zealand debt securities shrank $3.27 billion in the December quarter, and showed the third quarterly contraction for foreign investment in general government debt securities.

Butcher said interest rates in New Zealand would have to lift at some point if global interest rates continue to rise, but long-dated interest rates can't rise until the cash rate increases. The "hot money" has left New Zealand in the past year and a half as global interest rates have risen, he said, leaving the market with long-term investors, some of whom have been here for 30 years.

"What's important for LGFA is we are still seeing very strong offshore investor demand for our bonds," he said. "A number of offshore investors want to be in New Zealand for diversification purposes, they have a global fixed-income portfolio, so we are still tapping into that."

Butcher also discussed the financial covenants on its member councils, with all local bodies compliant as at June 30, 2017, and most have "sufficient financial headroom." Auckland Council is a special case and has been exploring options as it has reached its debt cap.

The council has committed to retaining its AA rating, meaning it will need to stay within the financial covenants set by LGFA, Butcher said. It needs more revenue to fund infrastructure, and is still working with central government on off-balance sheet mechanisms such as special purpose vehicles.

Auckland Council can borrow 2.5 times as much as it raises, so can borrow an extra $320 million from the $130 million raised from the regional fuel tax, Butcher said.

"That's not really going to be enough to fix Auckland's transport issues, so this is why there has to be a wider issue of what you can do to fund this infrastructure," he said.

"The first initiative was the housing infrastructure fund in 2016, the latest discussions are around Crown Infrastructure Partners, which has been taking place since July, August 2017. There is a lot of work being done to try and find a solution."