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Boom in Build America Bonds

Subsidized munis are such a hit that President Obama wants to expand the program.

In January, when cash-strapped Illinois decided to raise money for transportation projects, instead of issuing conventional tax-exempt municipal bonds, Springfield for the first time sold federally subsidized, taxable Build America Bonds.

“We were seeing BABs deals getting done at very attractive rates and wanted to take advantage of that,” explains John Sinsheimer, Illinois’s capital markets director. The net cost to the state: only 4.05 percent, a rate competitive with that on Treasuries. Demand was so brisk that Illinois — which faces a $2.5 billion deficit — was able to boost the sale from $750 million to $1 billion.

BABs have been on a roll. Authorized to finance state and local infrastructure projects as part of the Obama administration’s February 2009 stimulus bill, they hit a volume of $64 billion in 2009 — far above expectations. The draw: For issuers the federal government reimburses 35 percent of the interest costs; for investors the taxable interest rates compete with those on high-grade corporates. (The 25-year maturity Illinois bonds paid 6.16 percent.)

Now BABs may grow even faster. As part of his budget, President Barack Obama plans to make the BABs program, which had been scheduled to sunset at year-end 2010, a permanent funding option for cities and states. Moreover, although the interest subsidy would decline to 28 percent, universities and hospitals and perhaps even government deficits would become eligible for BABs financing. “Even at the 28 percent level, we’re going to get more BABs than at 35 percent, because the program contemplates such an expansion,” notes Christopher Meir, a strategist at Chicago-based Loop Capital Markets.

If the BABs proposal is adopted — some in Congress object to the $3 billion annual cost — analysts expect it to boost BAB issuance to between $100 billion and $130 billion this year, as issuers rush to take advantage of the 35 percent subsidy available in 2010. “There is no question that if some issuers want to avail themselves of a higher subsidy, they are going to consider doing issues this year instead of next year,” says John Hallacy, municipal strategist at Bank of America Merrill Lynch. “It is definitely going to pump up volume this year and may take some volume away from 2011.”

To be sure, BABs are only a part of what has become a vibrant market for munis, as states and cities contend with the worst budget crisis since the Great Depression. Forecasters expect a record $435 billion to $450 billion in muni issues this year, easily topping 2009’s $407 billion (of which roughly 16 percent was BABs). By contrast, just $387 billion of municipal bonds were issued in ’08.

California, despite a budget deficit projected at nearly $20 billion, is among a number of states contemplating issuing revenue anticipation notes this year. Up to 12 states may do unemployment compensation bond issues of $1 billion to $2 billion to refill their depleted coffers. And other states are looking at revenue, fee-for-service and public-private partnership securities.

California was an enthusiastic early adopter of BABs, doing a lot to establish a market for the bonds. Shut out of the credit markets for most of 2008, Sacramento nonetheless was able to sell $5.2 billion of BABs in April of last year. In fact, the state received expressions of interest for $20 billion worth of BABs (Institutional Investor, “Economic Stimulus,” June 2009).

California’s BABs carried 25- and 30-year maturities, the latter yielding a taxable 7.43 percent, or 360 basis points more than 30-year Treasuries at the time. California, however, got away with paying a net 4.83 percent on the 30-year BABs once the federal subsidy was factored in, or some 100 basis points less than it was paying at the time on tax-exempt munis. In late February one of those 30-year BABs was yielding 7.55 percent.

California Treasurer Willlam Lockyer told II last summer that the state’s taxpayers stood to save $1.1 billion to $1.7 billion over the life of the BABs. And since that initial issue, Sacramento has issued a further $4.39 billion of BABs.

“BABs played a major role in helping this state revive its infrastructure program,” says an aide to Lockyer. “They allowed us to access billions of dollars in the capital markets, which we would not otherwise have been able to do. The BABs program helped us restart thousands of projects and create or preserve tens of thousands of jobs.”

In spite of the sea of red ink washing around cities and states, munis in general have a well-deserved reputation for safety. Moody’s Investors Service found that there were zero defaults on the 14,775 general obligation municipal bonds issued between 1970 and 2000. The same was true of 1,894 water and sewer bonds and 251 public university bonds. In fact, there were only three municipal bond defaults over that entire period.

Still, Fitch Ratings has warned municipalities that even to publicly discuss filing for bankruptcy could cause their ratings to be downgraded. “If bankruptcy is being actively considered, Fitch will assess whether the entity’s current rating should be maintained, as consideration of bankruptcy not only indicates severe financial stress but also a willingness to compromise the credit standing of bondholders through a bankruptcy filing,” the agency stated in a bulletin. And the mere mention of Vallejo, California, which sought Chapter 9 bankruptcy protection in May 2008, when it was unable to meet police and fire department payrolls, still makes many investors jittery.

But among munis, BABs have created a distinct niche. Matt Fabian, a senior analyst for Westport, Connecticut–based Municipal Market Advisors, reckons that foreign buyers that ordinarily shun munis have purchased 40 percent of BABs. “What the program does,” he says, “is open the market to a whole world of taxable investors.” Among the newest ones: U.S. pension funds that view BABs as a diversification play that doesn’t carry a lot of risk.

Most states now issue a combination of BABs and tax-exempt muni bonds to take advantage of differences in the yield curve over the long term. Loop Capital’s Meir believes the reduction in the federal government subsidy will alter the BABs-to-munis ratio. “While this year it may be 50 percent BABs and 50 percent tax-exempts, next year it might be 40 percent BABs and 60 percent tax-exempts,” Meir contends.

Brian Mayhew, chief financial officer of northern California’s Bay Area Toll Authority, which issued $1.4 billion of BABs in 2009, adds that a reduced subsidy would make the calculus of whether to issue BABs or tax-exempts more complicated.

“Before, it was such a clear spread — 50 basis points of overall value — and it really was pure gain,” he notes. “Now you’re going to want to do more analysis up and down the scale, but BABs will still be a strong factor.”

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