ANALYSIS-Build America Bonds bring “a game-changing moment”

February 3, 2010

By Lisa Lambert and Karen Pierog

WASHINGTON/CHICAGO, Feb 3 (Reuters) – The budget President Barack Obama proposed on Monday may revolutionize the $2.7 trillion U.S. municipal bond market by expanding a taxable bond program and changing how many states and cities finance daily operations and big projects.

“I think it’s a game-changing moment,” said Chris Mier, a muni market strategist at Loop Capital Markets in Chicago.

Obama proposed expanding and making permanent taxable Build America Bonds, which were created in the stimulus plan last year to finance infrastructure.

The bonds give issuers a federal rebate equal to 35 percent of interest costs, a subsidy so steep that state and local governments have rushed to sell $71 billion of BABs since they debuted in April.

The bonds helped revive the tax-exempt municipal bond market, which states, cities and municipalities tap to raise funds for schools, hospitals, roads and sewer systems. That market had stalled during the credit crisis and was all but frozen at the beginning of 2009.

Obama would like the program, which expires at the end of this year, to become permanent and cover a wider universe of financing, but he also suggested dropping the subsidy to 28 percent.

The decreased subsidy would likely concentrate BABs issuance into longer maturities, according to Mier. They now hover in the 15 years and beyond maturity range.

This in turn will make long-term tax-free debt scarcer, said Vincent Harrison, a portfolio manager at Dupree Mutual Funds in Kentucky who is already struggling to buy tax-exempt bonds for a long-term fund because of BABs.

“When they sit down and do the math — if it’s only a 28 percent subsidy — the break-even is longer out on the curve and it’s only beneficial to A-rated and below,” he said, referring to debt with lower credit scores.

In the near term, many issuers will rush into the market to get the deeper 35 percent subsidy before Obama’s budget is approved and further squeeze tax-exempt supply, said Alex Grant, portfolio manager for RS Tax Exempt Fund in New York.

Even before Obama’s proposal, Loop Capital had forecast 2010 BABs issuance at $130 billion or about 30 percent of total volume.

The lower subsidy rate though will not shrink the volume of BABs issued over time, because the program would be expanded to areas currently off limits — refundings, nonprofit debt issues, and cash-flow notes, Mier said.

Remaining tax-exempt debt could be bid up in price due to scarcity, creating richer tax-exempt ratios to U.S. Treasuries and lower borrowing costs, he added.

Even with a smaller rebate, BABs “should keep a lid on the rise in tax-exempt yields,” and lower borrowing costs for issuers, said John Mousseau, a portfolio manager at Cumberland Advisors, in a commentary.

They would also allow issuers “to advance refund older, higher-coupon bonds, thus lowering overall future interest costs,” he said.


Nevada State Treasurer Kate Marshall said her state saved 100 basis points in its last issuance by using BABs.

“To the extent that you can lower your costs that’s a good thing, especially right now with states feeling the pinch — more than feeling the pinch,” she said, referring to the big budget shortfalls facing most states due to the recession.

An expansion would also widen the universe for municipal debt.

“It would just open up the market to buyers who don’t need tax exemption,” said Paul Rosenstiel of San Francisco investment bank De La Rosa & Co and former California deputy state treasurer. “Right now if the state or a local government needs cash-flow borrowing, the lowest-cost way of doing that is to do a tax-exempt. But that limits the buyer pool.”

For portfolio manager Grant, the smaller rebate may prove too small. BABs buyers have wanted the debt to be “non-callable,” but tax-exempt issuers are used to being able to call in their debt.

With the lower subsidy, the issuers will not be saving as much money and they will still have lost the callable feature on their bonds, he said. (Additional reporting by Jim Christie in San Francisco; Editing by James Dalgleish)

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