Michigan Sells Long-Awaited $280M Garvee Offering as BABs

CHICAGO - Michigan entered the market yesterday with its long-planned $280 million issue of Federal Highway Administration grant anticipation revenue vehicles, becoming what market participants said is the first Garvee issue to tap the taxable Build America Bonds program.

The deal has long been in works - anticipated since the Michigan Department of Transportation completed its 2007 Garvee sale - but was reshaped due to the market turmoil of the last year as officials sought to improve the deal's appeal by curbing some risks associated with the credit.

The state accomplished its goals - winning upgrades from Standard & Poor's and Moody's Investors Service - by improving investor protections in the bond covenants. Michigan lifted debt service coverage ratios and lowered risks associated with the re-appropriation of federal highway funds.

The transaction underwent further revisions in recent weeks as shifting spreads increased the economic benefits of the BAB program and its direct-pay 35% interest subsidy from the federal government earlier on the yield curve.

The Garvees carry an 18-year final maturity and since BABs were introduced to the market in April, their savings over a traditional tax-exempt issue had been further out on the yield curve. Officials left open the option to divide the issue into a tax-exempt and taxable piece but ended up selling all of it as taxable BABs.

The Michigan DOT's finance director Myron Frierson said he returned to the transportation commission two weeks ago for clearance to use the BAB program with an estimated savings expected of about 40 basis points. "It became clearer in the last couple days that we could achieve the lowest interest costs by using BABs," he said.

Merrill Lynch & Co. was senior manager and Citi was co-senior manager on the deal. Public Financial Management Inc. was financial adviser, Miller Canfield Paddock & Stone PLC was bond counsel and Dickinson Wright PLLC was co-bond counsel.

The bonds mature mostly in 2027, with a 2012 maturity worth $5 million, yielding 4.75% priced at par in 2012, or 3.09% after the 35% federal subsidy, and 7.69% with a 7.625% coupon in 2027, or 5.00% after the subsidy, respectively. Bonds maturing in 2027 were priced to yield 325 basis points over the comparable Treasury yield. The bonds are callable at par in 2018.

Frierson said that earlier in the deal's planning stages, investor aversion to risk drove the department's decision to enhance bondholder protections in hopes of winning a credit boost. "We wanted to make sure the market was comfortable with the issue and we had noticed a significant spread between the single-A and double-A credits," Frierson said.

The bonds are repaid with the pledged state share of Federal Highway Administration funds. They are secured by reimbursements for project work, rather than by reimbursements directly for debt service, as is the structure on many Garvee issues.

Michigan does not pledge a secondary source of revenue like many other states - considered a credit weakness given the long maturity and federal re-appropriation risks - but it can appropriate other transportation revenues if federal funds fall short. The current federal highway program, known as SAFETEA-LU, expires in September.

The sale is a follow-up to Michigan's 20-year issue of $478 million of Garvees in 2007. About $118 million of the proceeds will finance the final projects included in the state's 2005 Jobs Today program launched to speed up $600 million in infrastructure projects. The remaining proceeds will pay for approved road and bridge preservation projects.

The new bonds carry a risk of three six-year federal highway program reauthorization cycles. To calm concerns over the reauthorization risk, the state included in the new transaction's covenants an accelerated redemption feature between 2018 and 2021 in the event that the federal highway package is not reauthorized at a level that provides three times debt service coverage.

In an additional move that benefits both the 2007 and 2009 bonds, Michigan limited future leveraging of federal funds by doubling its maximum annual debt service coverage requirement to three times from 1.5 times. Current grants of $734.5 million provide five times coverage. The change "addresses a significant credit weakness in the program," Moody's analysts wrote.

Moody's assigned a Aa3 to the new transaction and upgraded to A1 from A2 the 2007 bonds. Standard & Poor's assigned a AA to the new deal and upgraded the 2007 bonds to AA from AA-minus.

"The rating reflects MDOT's strong federal and state programmatic support, the state's history of maximizing its share of federal reimbursement revenues, and a strong additional bonds test that requires historic three times MADS coverage," wrote Standard & Poor's Robert Hannay. "Credit strengths also include high maximum annual debt service coverage provided by historic receipts and no plans for additional Garvee debt at this time."

Michael Scarchilli contributed to this story.

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