Any new variation on municipal financing is an interesting event to investors. And this innovation is going to represent a tidy portion of the bond market
Among the many economic stimulus provisions in the American Reinvestment and Renewal Act of 2009 is a short-term program to expand financing alternatives for state and local governments. The legislation creates a new category of taxable municipal bonds (Build America Bonds or BABs), designed to facilitate financing of state capital expenditures and operations. New issues of BABs, which must be issued before 2011, already are reaching the market, with implications many investors should consider.
ABCs of BABs
Issuers may elect to treat obligations that would otherwise qualify as tax-exempt (except private activity bonds), as BABs. Interest on BABs will be taxable for federal purposes. While this will presumably increase the yield investors demand, the federal government plans to reduce the issuer's financing cost in either of two ways:
Tax Credit — Investors will be able to claim a tax credit equal to 35 percent of the interest received on a BAB. But the credit will be includible in gross income. To generate the same yield as a taxable bond, Congress expects that tax credit BABs need to bear interest at about 74 percent of the coupon on a comparable taxable bond, based on this reasoning:
Assume that a taxable bond, issued at par, pays $100 of interest annually. Municipality A issues a BAB bearing interest of $74.10. The bond entitles the holder to a tax credit equal to about $25.90 (that is to say, 35 percent of the interest payment), bringing total taxable income on the bond to $100. The after-tax yield on the BAB is the same as on the taxable bond, but interest payable by the issuer is substantially less.
As with some existing tax credit bonds, the tax credit on the BAB can be stripped from the bond and sold separately. As a result, investors who do not directly need the tax benefit nevertheless can profit by selling it to other taxpayers.
A BAB may contain original issue discount (OID), but recent guidance issued by the Internal Revenue Service clarifies that no OID will qualify for a credit.1 The bond may not, however, bear more than a de minimis amount of bond premium, which will prevent issuers from paying above-market interest rates on an obligation intended to qualify as a BAB.
Direct Subsidy — For certain “qualified bonds,” an issuer may elect to receive a direct subsidy payment from the federal government in lieu of a tax credit to investors. The payment will equal 35 percent of the interest payable on the bond (45 percent in the case of a “recovery zone economic development bond”). The federal subsidy ensures that the issuer does not bear the additional cost of the higher yield. To qualify for the subsidy, the issuer must use all but a reasonably required reserve of bond proceeds for capital expenditures. Investors will receive no federal tax benefit, and thus will presumably purchase the bonds only if the yield and credit characteristics are attractive relative to other taxable investments.
The direct subsidy BABs may draw increased interest from investors who traditionally have no need for tax-exempt obligations. Foreign investors, tax-exempt organizations, and some institutions who've previously tended to purchase taxable debt because of the higher yield may all be attracted to BABs, possibly increasing the capital available to issuers. And since direct payment bonds must principally finance capital expenditures, additional capital may make it easier for issuers to finance infrastructure spending.
An important characteristic of BABs is that, although interest income is taxable for federal purposes, the bond is in other respects a typical municipal obligation and may qualify for a tax exemption at the state level.2 As with tax-exempt obligations generally, BABs will not necessarily be tax-free to out-of-state holders. The tax treatment of a BAB therefore will be somewhere between a federal obligation (taxable federally; tax-free in all states) and a municipal bond. So, holders need to be aware of state tax implications when calculating the after-tax return on the bond.
Investors in municipal bonds are all too familiar with the problem of deducting interest expense attributable to tax-exempt holdings.3 Presumably, because income from BABs will not be exempt from federal tax, for federal tax purposes interest expense attributable to BAB holdings should be tax-deductible. But if interest qualifies for a state exemption, investors need to be mindful of potential state tax limitations on interest deductibility. For federal purposes, it appears that interest expense attributable to BAB holdings would qualify as investment interest, subject to the normal provisions of Internal Revenue Code Section 163(d).
There is no specific cap on the amount of bonds that may be issued, and no restriction on the term or structure of interest payments. Rules contemplate both fixed and variable-rate bonds, although some analysts expect the issuances principally to take the form of fixed-interest bonds. Initial expectations are for total issuances to be in the range of $100 billion to $150 billion over the life of the BAB program (that is to say, until the current provisions expire in 2011). As a comparison point, in early 2009, the volume of outstanding municipal obligations totaled about $2.7 trillion.4 Moreover, the direct payment bonds will be eligible for inclusion in bond indices, at least where the issuance reaches sufficient size. This should have a positive impact on liquidity.5
Although the market for BABs has not yet developed, analysts estimate that about 65 percent of the traditional buyer base for municipal bonds is drawn to credit quality and yield relative to comparable products in the market. Certain investors with particular sensitivity to taxes, including mutual funds and some insurance companies, typically do not participate in the taxable municipal market.6 To the extent issuers use BABs to finance their debt, they will reduce the supply of tax-exempt securities offered to investors, which may exert a downward pressure on tax-exempt yields as the existing demand pursues a diminished supply of exempt bonds.7
Implications for Investors
Investors will presumably analyze BABs as they would other taxable bonds, focusing on yield and credit quality. Residents of states with an income tax likely will be interested in the possibility of a state tax exemption on the interest income. Recent market conditions, where yields on municipal bonds have been higher than normal, may present an attractive opportunity. (See “Tax-exempt vs. Taxable Yields,” p. 43.)
For two bonds with the same terms and credit quality, an investor would presumably select the one with the better after-tax yield. A taxable municipal bond (assuming a 35 percent tax rate) would have to yield a total of 7.69 percent to produce the same after-tax yield as a tax-exempt obligation. In the case of a “direct payment” BAB, the federal government would pay the cost of the additional yield. That yield represents a significant increase over the coupon on a comparable fully taxable bond; investors who are in the market for taxable instruments presumably would opt for the BAB alternative. Even if demand pushes the yield on BABs down, they would remain a preferable alternative as long as their yield stays above the taxable bond yield.
Of course, this analysis is a much simplified version of the appropriate real-world analysis. There could be significant differences in the structure of two bonds (for example, call features), and even if bonds hold comparable ratings, an investor should carefully consider credit quality issues. The nature of the issuing entity, whether it is a state general obligation bond or a revenue bond, and other features relating to the security of payment of course remain fundamental parts of the analysis. And, as noted, tax considerations are somewhat more involved if state taxes are an issue, as corporate bonds are subject to state tax while a BAB may not be.
As of this writing, about $7.4 billion in BABs already have come to market. Two issuances make up the bulk of that supply. California issued $5.2 billion in BABs (out of a total issuance of $6.9 billion), and the New Jersey Turnpike Authority issued over $1.3 billion in direct subsidy 30-year BABs,8 an offering that was substantially larger than the initial expectation. The New Jersey bonds were priced to yield 7.4 percent, about 370 basis points above Treasury obligations, while the California bonds were priced at 7.55 per-cent. Demand for the California obligations drove the price up noticeably after the issuance.9
Nice Market to Be In
Although BABs are apparently a short-term innovation, at the end of two years the total volume of BABs could be around 5 percent of the total municipal market, making a significant supply of such bonds available to investors. Because the number of municipal issuers with favorable credit ratings is significant — about 70 percent of municipal bonds are rated AA or better, and over 90 percent have a rating of “A” or higher10 — these (presumably) higher-yielding bonds could be an interesting addition to fixed income allocations, particularly for investors or related entities who benefit from a lower tax rate. — The author thanks his colleagues Meghan Muntean, an analyst, and Elizabeth Fell, fixed income strategist, both at Barclays Wealth in New York, for their comments on drafts of this article. Any errors are the author's fault.
- Internal Revenue Service Notice 2009-26 (released April 3, 2009) (citing legislative history).
- See, for example, the Supplement to the Preliminary Offering Memorandum for State of California General Obligation bonds (April 14, 2009), in which bond counsel takes the position that interest on the Build America Bonds (BAB) portion of the offering will be taxable for federal purposes but exempt from California state income tax.
- Internal Revenue Code Section 265(a)(2).
- Peter de Groot, Build America Bonds (Barclays Capital 2009).
- Austin Applegate, Basics of Build America Bonds (Barclays Capital 2009).
- See de Groot, supra note 4.
- Stan Rosenberg, “MTA Prices $750 Million of ‘Build America Bonds,’” wsj.com, April 23, 2009.
- Bryan Keogh, “California Build America Bonds Hand Buyers $212 Million Gains,” Bloomberg.com, April 23, 2009.
- See de Groot, supra note 4.
Matthew Brady is a managing director at Barclays Wealth in San Francisco
Tax-exempt vs. Taxable Yields
The general obligation bond appears more attractive than corporate debt
|Description||Tax-Exempt Yield||Tax-Equivalent Yield||Spread to Treasury*|
|Tax-exempt, 30-year, AA-rated General Obligation||5.00%||7.69%||412 bp|
|30-year, AA-rated Corporates||4.24%||6.52%||295 bp|
|*Represents the excess yield in basis points (bp) above Treasury bonds|
|Note: This chart is based on simplified assumptions and market conditions in first half of 2009|
|— Applegate, Basics of Build America Bonds (Barclays Capital 2009)|