Buy Side

Market Still Makes Build America Bonds Pay a Penalty

Investors and traders continue to punish Build America Bonds for their novelty and illiquidity.

While the market is no longer exacting the severe penalties BABs suffered when they were first issued, these new taxable municipal bonds persist in commanding lower prices than comparably rated corporate bonds despite munis’ more benign default history.

BABs, enacted through the American Recovery and Reinvestment Act in February, are taxable alternatives to traditional tax-exempt state and local government debt.

Under the federal program, instead of selling tax-exempt bonds, governments can sell taxable bonds and receive a cash subsidy from the Treasury equal to 35% of the interest cost.

Since the first issues came to market in mid-April, issuers have sold $18.5 billion of BABs.

At the outset, analysts from Barclays Capital projected issuance of $150 billion in the first two years of the program, after which the legislation sunsets.

The concept of the program is to allow issuers access to new types of investors that do not pay federal taxes in the U.S. and therefore have no reason to buy tax-exempt bonds: pension funds, 401(k) investors, foreign investors, and insurance companies without taxable profit.

When BABs first hit the market, investors demanded substantial yield premiums over Treasuries.

The University of Virginia first tested the market with a 30-year BAB in April. Traders for several weeks slammed the bond with an interest rate at least 280 basis points over the 30-year Treasury rate, according to Bloomberg LP,  based on a “zero-volatility” spread, which measures the excess spread for each payment on a bond over a corresponding Treasury spot rate.

The New York Metropolitan Transit Authority’s 30-year BAB did just as badly: a month after issuance, the bonds still yielded 240 basis points more than the 30-year Treasury.

Traders and investors said the market was demanding a “newness” premium to compensate for the risk of taking on a product few investors knew anything about.

More than three months later, the premium has eased for some issuers, but it has hardly vanished.

The University of Virginia’s bonds still yield 204 basis points more than the 30-year Treasury, while New York MTA’s yield 259 basis points more, based on the zero-volatility spread.

A trader in New Jersey said the market continues to demand plump yields from BABs because they remain unproven.

“These are relatively new securities with no track record,” the trader said. “Pension fund managers that have been buying taxable debt for their career aren’t used to these bonds.”

The tax-exempt and taxable markets are “completely two different worlds,” the trader said.

The trader pointed out that some issuers, such as Ginnie Mae, sell bonds in both the tax-exempt and taxable markets, with no parity in pricing.

Other traders and investors think the spread between the two means nothing more than an easy buying opportunity.

“There’s no real good reason for it,” said Terry O’Grady, head muni trader at FMSbonds Inc. “It’s just an inefficiency. ... It’s the imperfections of the municipal marketplace. The muni market is far from perfect. It does not do a great job of ­assessing the risk.”

Whatever the reason, spreads have started to creep back up in the past six weeks.

When the New Jersey Turnpike Authority sold 30-year BABs in late April, the bonds yielded 327 basis points more than Treasuries, based on the ­zero-­volatility spread.

According to Bloomberg, the spread sank to as low as 203 basis points on June 5. It has since swelled back to 274 basis points.

The Illinois State Highway Toll Authority’s BABs improved from a 316-basis-point zero-volatility spread May 12 to a 189-point spread on June 5. It has since fattened back to 223 basis points.

Phil Fischer, head muni strategist at Bank of America-Merrill Lynch, created a sort of BAB index, averaging the yields on some of the biggest bonds in the sector.

Fischer concluded that for most of this month, BABs yielded on average more than 150 basis points higher than double-A rated corporate bonds, and more than 50 basis points above single-A corporate bonds, based on Merrill Lynch corporate bond indexes.

That excess flouts historical default patterns.

The historical default rate on munis with investment-grade ratings from Moody’s Investors Service is 0.07% and from Standard & Poor’s is 0.2%. The default rate on corporate bonds with investment-grade ratings from Moody’s is 2.09%, and from Standard & Poor’s is 4.1%.

Even with that disparity, it is not hard to find corporate bonds yielding less than BABs with superior ratings.

BABs issued by the Illinois State Highway Toll Authority, rated AA-minus, yield a few basis points more than longer-maturity bonds issued by Teva Pharmaceutical Industries Ltd., a generic drug manufacturer based in Israel rated ­triple-B, based on data from the Municipal Securities Rulemaking Board and Bloomberg.

At Standard & Poor’s, the default rate on BBB corporate bonds is more than 10%.

Fischer thinks illiquidity explains much of the BABs’ spreads to corporate bonds.

Like tax-exempt munis, the taxable municipal market is not liquid. Despite stronger credit histories, munis can be tough to sell and investors who need to liquidate a muni position often pay the price.

According to trades reported through the MSRB, a dealer bought a 30-year N.J. Turnpike Authority BAB at 12:33 p.m. on July 23 for $111.76 per $100 face value.

A little more than two hours later, a dealer sold the same bond at $114.83.

The spread between what dealers pay and charge for the same bond, known as the bid-ask spread, is essentially a penalty incurred by investors trying to sell bonds in an illiquid market.

Even California, a universally known and heavily traded name, faces wide spreads

Yesterday, the MSRB reported two trades of 30-year California BABs within 11 minutes of each other.

A dealer bought the bond at $101.07 per $100 par value. Another dealer sold the same bond at $104.52.

“I am seeing secondary pieces, but it’s not like the corporate market where everything keeps moving back and forth,” said Mary Talbutt-Glassberg, vice president of fixed-income portfolio management at Davidson Trust Co. “It’s not as fluid as the corporate market.”

Ashton Goodfield, head of muni trading at DWS Investments, said many taxable-bond trading desks do not have credit analysts with experience studying state and local government debt.

The general unfamiliarity crimps BABs’ trading liquidity, she said.

Aside from unfamiliarity, many municipalities also insist on embedding their bonds with call options.

In the tax-exempt market, issuers can obtain call options cheaply.

According to Municipal Market Data, a 30-year muni with a call option only costs an issuer two basis points in extra yield over a muni with no call option. In the taxable market, investors impose a much harsher price.

Some taxable bond investors are not accustomed to call options, Goodfield said, and so call options hamper liquidity ­further.

Goodfield attributes the resurgence in spreads in the last six weeks to scary news about municipals, especially in California.

People who are not experienced in government finance might shield themselves from the space entirely rather than stomach risks they do not understand, she said.

“There have been some headlines about municipals recently that are making some of the investors a little concerned,” Goodfield said. “Those that don’t know the story as well might draw a line and say, 'I don’t want to have that problem.’ ”

One measure of BABs’ value of particular interest to local governments is the relationship between taxable and tax-exempt debt from the same issuer.

In deciding whether to issue BABs, local governments have to compare the rate they pay on tax-exempt bonds with the rate they pay on BABs, multiplied by 0.65. The Treasury covers the remaining 0.35.

BABs are appealing to issuers only if the yield times 0.65 is lower than the yield on tax-exempt paper.

In April and May, some issuers marveled at the savings realized through opting for BABs.

According to trades reported through Bloomberg, this advantage peaked last month.

The after-subsidy yield on the New York MTA’s BABs was less than 90% of the MTA’s tax-exempt yields on similar maturities for most of June.

Now, it is back above 90%, according to Bloomberg data.


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