Buy Side

BABs vs. Munis, Analyzed

SAN FRANCISCO — Build America Bonds rapidly gained investor acceptance in their first four months in the market, but they continued to trade differently from traditional municipal bonds during that period, according to preliminary findings from Loop Capital Markets.

Those are preliminary findings of a study of BABs that were sold alongside tax-exempt debt between April 20 and Aug. 20. Loop analyst and managing director Christopher Mier analyzed pricing data from issuers who sold traditional tax-exempt bonds and BABs on the same day. In all, the research compared 134 different BAB issues and 596 tax-exempt bonds identified by Cusip numbers.

BABs are taxable municipal bonds that were authorized under the American Reinvestment and Recovery Act in February to give issuers access to the bigger, deeper taxable bond market. The U.S. Treasury gives issuers a subsidy equal to 35% of the interest as a replacement for the traditional muni tax exemption.

Early BABs traded at wide spreads to Treasuries, and BABs have continued to yield more than similarly rated corporate debt. But Mier found that the spread over Treasuries narrowed by about half a basis point a day over the first four months of BAB issuance.

Data gathered by market participants show that in general the spread to Treasuries has fallen from an initial range of over 300 basis points to under 200, depending on the issuer.

“That’s a pretty significant reduction in the yield of BABs relative to Treasuries,” said Mier in an interview yesterday. “The market for BABs has gone through a period of discovery, growing acceptance, and growing familiarity that’s resulted in the narrowing of those spreads.”

The finding was still statistically significant even after excluding early adopters — issuers that paid the highest premiums relative to Treasuries.

Mier used multivariate regression to analyze the data, and said the results are preliminary because he plans to re-calibrate his model to determine how much of the decrease in spreads can be attributed to a broader narrowing of credit spreads more generally, and to expand his sample to include more small issues, among other things. His original sample only tested issues of $50 million or more.

Mier wants to study more small issues to understand why BAB investors seem to favor high-profile issuers, such as the University of Virginia or the New Jersey Turnpike Authority, over less well-known governments, such as a small Kentucky school district. Mier’s analysis found that high-profile issuers paid 16 basis points less in interest than their less-well-known counterparts, regardless of credit rating or other factors.

“If you’re a taxable buyer and you’re looking at a name like the University of Virginia, you’re probably going to assume that name is going to be more tradable in the secondary market than a very localized issuer, so you’d be willing to accept less yield,” Mier said.

While many municipal market participants have hypothesized that high-profile issuers get better terms in the market, that muni call provisions are costly, and that spreads are narrowing, Mier’s analysis seeks to quantify how much each of these variables has cost issuers.

“You could probably talk to 12 different underwriters and get 12 different numbers” about the benefit national names get in the market, he said.

He found that call provisions that allow issuers to redeem bonds prior to maturity — other than a “make-whole” call — added 44 basis points to the yields of BABs in his sample. That’s much bigger than the six basis points tax-exempt issuers paid for the option to call bonds.

Ten-year calls are standard in the muni market, but they’re unusual in the taxable market. Market participants have debated how much calls were costing issuers that insisted on having equivalent calls for their BABs. While a few have valued the calls with sophisticated option-pricing models, most have relied on benchmarks set in a few high-profile deals.

The size of the call penalty was so large that Mier wants to investigate further to see if he can find any other variable that might help explain some of the difference.

“I think it’s something that needs to be investigated,” he said. “Don’t make a determination based on this output, but give us some time to look into it.”

He also found unexpected results that run counter to conventional wisdom about BABs. State tax exemptions — which would theoretically add to the value of BABs in states where the interest is exempt from local taxes — made no statistically significant difference in the yields of BABs. Mier hypothesized that this result might change over time, depending on market conditions and the types of buyers in the market.

In another counterintuitive result, Mier’s research showed that issue size made no statistically significant impact on yields. Some underwriters advised municipalities to sell large BAB issues, assuming investors would pay up for the liquidity that big issues promise in the secondary market.

“We tested for size above the $50 million point, and it was not statistically significant,” Mier said. “Anecdotally, we found the BAB market to be receptive of smaller issues.”


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