Buy Side

Nassau BABs Deal Follows Trend of Longer Maturities

When Nassau County, N.Y., goes to market today with a $110 million competitive deal, it will follow a trend that has emerged since the creation this year of the taxable Build America Bonds program.

The county anticipates selling the longer maturities as BABs which will receive a federal tax subsidy of 35% on interest costs, while the shorter maturities will be tax-exempt.

Most of Nassau's bonds, $89.6 million, will be sold as tax-exempt serials maturing in 2011 through 2023 while the expected taxable BABs portion, $20.4 million, will have maturities in 2023 through 2025, according to the preliminary official statement.

Bidders will have the option to bid on the long end as either BABs or tax-exempt and the county will choose which way to go based on the lowest true interest cost after the BABs subsidy, said Nassau county debt manager Jeff Nogid.

The three biggest deals last month - floated by the Regents of the University of California, the New York State Dormitory Authority, and the North Texas Tollway Authority - all followed the same pattern of serial tax-exempt maturities in the short and mid-range followed by a big lump-sum BAB maturity at the long end.

This pattern has developed because issuers are finding that selling long-term BABs is cheaper than selling long-term tax-exempt bonds, while short-term tax-exempt financing is still cheaper than selling short-term BABs.

For example, about half of the $1.26 billion DASNY deal, which was a personal income tax offering sold on behalf of the state, was sold as BABs. The New York State Division of Budget concluded selling tax-exempt bonds was more economical with maturities out to 2022, and BABs were better after, said spokesman Matt Anderson.

He estimated the BAB portion of the deal produced gross savings of $168 million over the life of the bonds compared to selling them as tax-exempts.

"For longer-dated projects [the BABs program] gives us lower cost of funding," said Nogid. "It's still cheaper to issue tax exempt on the early maturities."

About $80 million of the deal will be used to reimburse the county for an early termination program approved this year by the state Legislature that encouraged county employees to retire or resign in return for a cash payment.

Moody's Investors Service rates the bonds A2. Standard & Poor's and Fitch Ratings assign their A-plus ratings.

Public Financial Management Inc. is financial adviser on the deal and Orrick, Herrington & Sutcliffe LLP is bond counsel.

The county has $2.79 billion of debt outstanding, which includes debt issued by the Nassau County Interim Finance Authority.

Like the DASNY deal, Nassau expects to switch from tax-exempt to BABs at around maturities after 2022.

"The taxable curve is a much flatter curve and the tax-exempt curve is a much steeper curve so at some point the two yields cross each other," Nogid said.

This trend reflects a discrepancy between the taxable and tax-exempt bond markets. For the past several decades, tax-exempt yield curves have been persistently steeper than taxable yield curves.

Since the beginning of this decade, the 30-year Treasury has yielded an average of 160 basis points more than the two-year Treasury. A 30-year swap on the London Interbank Offered Rate on average expressed a yield roughly 164 basis points higher than two-year Libor.

By comparison, based on the Municipal Market Data yield curve, during that time the 30-year triple-A tax-exempt muni has yielded an average of 217 basis points more than the two-year triple-A.

Municipalities that sell tax-exempt bonds, in other words, pay a harsher penalty for incurring longer-term debt than do taxable issuers.

In fact, BABs have hit the municipal market at a time when the tax-exempt curve is unusually steep. The 30-year triple-A currently yields 370 basis points more than the two-year, according to MMD.

The steeper municipal yield curve describes a schism that has long divided issuers from investors, said Jeffery Timlin, a portfolio manager at Sage Advisory Services in Austin.

Retail investors like to buy short-term bonds. Issuers like to sell long-term bonds.

On the buy-side, retail investors prefer to play it safe with shorter-term debt, said Peter Coffin, founder of Breckinridge Capital Advisors. Buying longer-term bonds introduces numerous risks that retail investors would just as soon avoid, mainly inflation. Nobody wants to be stuck holding a 30-year bond yielding 4.5% if inflation starts to flare up again, he said.

On the sell-side, municipalities' financing needs are ill-suited to short-term bonds, Timlin said. Companies are often better able to float short-term debt because many corporate projects - a factory, say, or the development of a new product - begin delivering cash after a few years. There is a shorter time horizon for when many corporate projects begin paying for themselves.

By contrast, many municipal projects are much longer-term. Local governments building schools, highways, or hospitals would hope to finance these projects over many years. Many municipalities sell tax-exempt bonds with serial maturities because they want level debt service over the life of the project, which could be decades.

The disconnect in the tax-exempt market between issuers and investors has led to low short-term rates and high long-term rates.

Many issuers are taking advantage of lower tax-exempt rates on the short end and opting for taxable rates on the long end.

In his weekly report yesterday, Phil Fischer, head of muni strategy at Bank of America-Merrill Lynch, concluded that many issuers have replaced long-term tax-exempt issuance with BABs.

He wrote that more than half of the BABs issued have carried maturities 30 years or longer.

Conversely, the percentage of tax-exempt bonds with maturities of 30 years or more is down to about 20% this year compared with more than 25% last year, Fischer said.

A new Wells Fargo index tracking BABs with an average maturity of 27.6 years reflects an average yield of 6.06%, according to Bloomberg. After a 35% federal subsidy, this implies the net interest cost on 27.6-year debt is 3.94%. By comparison, a 28-year tax-exempt triple-A muni based on the MMD scale yields 4.39%.

This all raises an obvious question: why would a long-term BAB carry a lower after-subsidy interest rate than a long-term tax-exempt muni?

The rift between issuers' borrowing preferences and investors' lending preferences should not prevent opportunists from taking advantage of higher long-term tax-exempt rates.

Fischer explained that normally arbitrageurs could be expected to buy long-term tax-exempt bonds until the tax exempt rate was more or less equal to a taxable municipal rate minus 35%.

Tax regulations foil what would otherwise be a profitable arbitrage strategy, he said.

Internal Revenue Service code section 265 eliminates some of the tax deduction for financial institutions on interest paid on borrowed money if that money is used to buy tax-exempt municipal bonds.

This impedes the use of arbitrage to bring long-term tax-exempt rates down, Fischer said, because it makes borrowing money to buy municipal bonds too expensive.

The upshot is that long-term tax-exempt rates remain inefficiently high, and long-term yields on BABs are attractive to issuers by comparison.


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