Buy Side

BABs Losing 'New Issue' Smell

The "newness" premium on Build America Bonds has thinned.

A month ago taxable municipal bonds issued under the BAB program carried higher yields than many investment-grade corporate bonds and even government bonds from emerging economies. Market participants said the additional yield reflected a "newness" premium to compensate for the uncertainties of investing in a novel product.

After a sharp rally in the sector, BAB spreads have narrowed significantly. Market participants say the tightening in part reflects growing familiarity with the product. Over the long term, these people say, yields could come down more as awareness and comfort eradicate more of the newness premium.

At the National Federation of Municipal Analysts Conference in Seattle this month, Gerry Lian, executive director at Morgan Stanley Investment Advisors, presented yields on a number of taxable bonds side by side.

New York Metropolitan Transportation Authority BABs maturing in 2039 yielded 7.34% at pricing on April 22, or 109 basis points more than United Parcel Service corporate bonds with similar maturity.

At issuance April 21, California general obligation BABs maturing in 2034 yielded 7.43%, 148 basis points more than Southern Corp. bonds maturing five years later.

The New York MTA bonds even yielded more than debt issued by Brazil, and the California bonds yielded more than Mexico government bonds.

Judging solely by credit quality, this would not make sense. According to Moody's Investors Service, the default rate on investment-grade corporate bonds is 2.09%. The default rate on investment-grade munis is 0.07%. The default rate for all corporate bonds is 9.7%, according to Moody's. For munis, it is 0.1%.

Lian attributed the BAB spread to a few factors, including less stringent disclosure requirements on municipalities than on corporations and relative illiquidity.

A big factor was the "newness" premium, Lian said.

Chris Mier, managing director at Loop Capital Markets LLC in Chicago, said, "In the process of the creation of this new market, there's going to be somewhat of a yield premium the issuers have to pay to be the first in."

Underwriters pricing the deal did not know how many buyers they would find for the product, Mier said, and dealers did not know what investors were looking for. "There were a lot of uncertainties in the first few deals. There's a process of price discovery. ... Both sides are seeking information that they don't have yet."

The federal government authorized BABs through the American Recovery and Reinvestment Act, which was enacted in February.

The legislation lets state and local governments sell taxable bonds and receive a subsidy equal to 35% of the interest cost in lieu of the tax exemption typical in the municipal market.

Taxable muni debt was for a long time a backwater of the bond market, said Peter Demirali, who manages $250 million of taxable munis at Cumberland Advisors in Vineland, N.J.

A lot of bond firms did not deal with taxable munis or know how to value them, he said. When the first BAB deals came to market, dealers priced the paper to make sure they could sell it, since nobody wanted to be saddled with unsalable inventory.

Now that the market has warmed to taxable munis, the newness premium has shrunk.

According to Bloomberg LP and trades reported to the Municipal Securities Rulemaking Board, the MTA BABs that yielded 109 basis points more than UPS bonds last month yielded about 33 basis points more Wednesday.

The New Jersey Turnpike Authority, whose BABs maturing in 2040 last month yielded 141 basis points more than Berkshire Hathaway Inc. bonds with similar maturity, now are yielding about 64 basis points more.

Peter Coffin, founder of Breckinridge Capital Advisors, said BAB spreads over corporates have tightened significantly as the market has swallowed taxable issues without a hiccup.

"We've seen those spreads tighten, and we would expect they'd continue to tighten," said Coffin, whose Boston firm manages $9.25 billion, including $500 million of taxable portfolios. "We've seen that come in as investors get more comfortable and familiar with BABs. ... Build America Bonds will be valued at levels more consistent with other taxable bonds. What it takes is investors looking at the Build America Bonds as more than just a short-term opportunity."

Demirali said investors looking at BAB spreads as a short-term opportunity might be disappointed. After a crush of interest in the product, BABs have probably now hit a "wall."

In the longer term, he said, BABs could yield less than corporate bonds, but for now yields will likely have to creep back up to keep investors interested.

"We're starting to see more of these bonds come back into dealer hands as people have taken profits on spread trades," he said. "You're seeing many more of these bonds come back out into the Street."

For example, Demirali had been considering New Jersey Transit's upcoming 30-year BAB deal, with price talk this week of yields of 7%.

However, now that the whisper number has edged down to 6.85%, he said, he is no longer interested.


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