When taxable Build America Bonds were introduced to the market in April, one attraction for issuers was said to be the wider investor base they would garner, in contrast to the limited market for traditional, tax-exempt municipal bonds. But while BABs have been successful in expanding liquidity in the muni market, purchases from abroad remain relatively shallow.
This is surprising given the excess spread BABs offer over Treasuries. According to data obtained from Wells Fargo & Co., yields in October ranged from 173 basis points to 189 over Treasuries, and in late August the spread reached 207. Moreover, yields were much higher when the program began. At its inception in mid-April, the University of Virginia offered a $250 million BAB deal with a 6.20% coupon, giving investors a 245 point spread over the benchmark 10-year Treasury.
Chris Mier, managing director at Loop Capital, attributes the tepid response to the fact that BABs are still wet behind the ears. “There still hasn’t been the overall acceptance and understanding of the BAB market that’s needed to really get the market to some sort of equilibrium,” he said. “There’s going to be substantial caution. I think we have to give the market a little more time.”
Build America Bonds, which as part of the Obama administration’s stimulus package give issuers a 35% subsidy on the taxable interest paid, have grown to become a $47 billion market by this week. With that kind of size more attention is being devoted to the market, and a response from foreigners could be expected in the medium term.
“You’ve already had domestic investors involved, and internationals are next,” said John Mousseau, vice president of Cumberland Advisors. “It’s like anything else — the comfort level has to build up.”
However, Patrick Brett, municipal desk strategist at Citi, which owns the largest bank municipal portfolio in the U.S., said that while the value of the BAB market has been hard for U.S. buyers to ignore, overseas asset managers haven’t been as quick to ramp up their muni research to assess and then access the market.
Brett, who recently spent a year in Hong Kong and a year in London, added that 80% to 90% of the overseas press has a negative bias against the muni market. “A lot of it is about budgetary pressures and their political implications,” he said.
Another concern is the decline of the dollar. An investor who purchased BABs in mid-April would have earned a total return of about 8%, according to an index published by Wells Fargo. That would seem to be a pretty hefty gain, but for a European buyer the investment would be a 3.53% loss as the greenback has fallen 11.53% against the euro over the same period.
“Undoubtedly, some of those investors would probably feel like the market has gone against them because of [the decline of the dollar],” Mier said.
Added Mousseau: “For foreign buyers who are not in hitting mode, they don’t want to keep seeing their portfolios be battered in local currency terms because of the dollar. So you just hope they don’t reach a point where they throw their hands up and go on a buyer’s strike.”
However, Citi’s Brett was skeptical that the dollar’s decline was playing a major role. “That hasn’t really stopped people from buying Treasuries or U.S. corporates,” he said. “It’s a negative headwind for all U.S. dollar asset classes, but other U.S. dollar asset classes have seen inflows from foreign investors.”
Indeed, this week when the Treasury auctioned a record-breaking $123 billion of Treasuries, there were no signs of foreign demand letting up. The benchmark 10-year yield began the week at 3.58% and fell to 3.46% by Thursday morning.
A more likely scenario may simply be that the traditional foreign buyers of taxable municipals are gone. Prior to the credit crunch, taxable issuance had been between 6% and 8% of new municipal bonds from 2004 to 2008, according to Thomson Reuters.
Faye Boatright, a managing director at Rice Financial Products Co., said the foreign buyers in that market were mainly financials — European banks like Dexia in Belgium or the German-Irish Depfa Bank Plc — that were buying the securities on a levered basis.
“The foreign banks were buying them, asset-swapping them, and kind of tucking them away until maturity,” Brett said. “Those buyers, not surprisingly, were hit hard by the credit crunch, and are generally repairing their balance sheets. So they are not in an asset-acquisition mode.”
Boatright said the appeal of certain taxable municipals before the credit crisis was their low risk-weighting.
Overseas banks “wouldn’t have to allocate a lot of capital to the bond versus, say, buying a revenue bond or a corporate bond,” she said. “Those entities haven’t been as profitable throughout the credit crisis and a lot of them stopped buying.”
That makes the taxable muni market today “basically the opposite of what it was [before the crisis],” Brett said. “It’s now mainly real-money domestic buyers, not the levered foreign buyers.”
On the domestic side, Boatright said the market for BABs is healthy. “When you look at the list of buyers you see very broad distribution with a lot of buyers participating,” she said. “Although certain buyers might not be in, it’s still attractive to a very wide net of the taxable bond base.”
Yet the foreign market in U.S. munis is far from dead. From the BAB program’s inception in early April to the end of June, the market issued $15.618 billion of new BABs, according to Thomson Reuters. During that time, the Federal Reserve’s quarterly look at municipal securities and loans recorded that overseas investment in the muni market increased by $5.6 billion, to $45.6 billion in total. If all of that investment was in BABs, foreign purchases would take up more than a third, or 35.9%, of the market.
Chris Mier said those numbers indicate that foreigners “were significant participants” in the BAB market. Unfortunately, the Fed data does not indicate whether those purchases were of ordinary municipals, other taxable munis, or BABs.
Brett, who watches the deals closely, said “the vast majority of buyers are domestic,” but he noted that foreigners are involved through other channels. “They are certainly investing indirectly via U.S.-based asset managers, so there is definitely foreign capital finding its way into the market,” he said. “But there have been relatively few people sitting in foreign capitals actually putting in orders.”
More surprising for BABs, according to Boatright, is that pension funds aren’t buying more.
“I thought that, just like other corporate buyers, they would see this as an opportunity to diversify into munis, which have lower default rates in general and represent a higher-quality asset class than general corporate bonds,” she said.
Indeed, some in the market consider BABs to be akin to Treasuries with higher yields. Citi’s Brett did not quite agree with that assessment, but he said BABs were “similar to a Treasury in that it’s also backed by the full faith and credit obligation of [a government].”
Added Mier: “Certainly one would think that a pension fund would have an interest in a 30-year taxable instrument because their liabilities go out quite a long way.”
The question going forward is whether Congress will extend the program beyond 2010. If it is killed off, a risk is that there could be a flood of issuance in its final months, which could send yields higher across the muni market. Alternatively, some sources say the program will likely continue but that new rules will be imposed, such as lowering the subsidy payments, capping the issuance amounts, or limiting the types of projects for which the funds are eligible.
