SAN FRANCISCO — California plans to sell as much as $4 billion of taxable general obligation bonds next week, including billions of dollars of Build America Bonds.
The state will use the BABs to finance traditionally tax-exempt projects — including construction of children’s hospitals, water infrastructure, prisons, and schools — and will sell straightforward taxable bonds that finance traditionally taxable projects, such as affordable housing and stem cell research.
The state hasn’t yet decided exactly how much of the deal will be BABs, but the deal is likely to be the biggest such offering to-date and will set a benchmark for future transactions. The BAB program was authorized in the America Recovery and Reinvestment Act in February.
The stimulus package allows municipalities to sell taxable BABs and to receive a 35% interest subsidy from the federal government. While it gives issuers the option of allowing investors to claim tax credits of the same value, California plans to take the direct subsidy.
“The Build America Bonds will provide taxpayers a better deal than traditional tax-exempt debt,” said Tom Dresslar, a spokesman for California Treasurer Bill Lockyer. “We think we’re going to get some good savings.”
The state and its financial adviser — Public Resources Advisory Group — are betting the combination of broader liquidity in the taxable market and the 35% federal subsidy will combine to produce even lower rates than the state gets in the tax-exempt market.
The first public sales of Build America Bonds came to market this week. On Wednesday, the University of Virginia priced $250 million of BABs. The bonds, which are rated triple-A by all three major ratings agencies, priced at a taxable rate of 6.22%, according to underwriter JPMorgan. The taxable rate was 32% above Municipal Market Data’s tax-exempt triple-A GO curve. That means the 35% federal subsidy made the BABs a better deal for the issuer than traditional tax-exempt debt.
The University of Minnesota also sold $35 million of BABs Wednesday. Net of the federal subsidy, the 20-year, double-A rated bonds yielded 3.81%. That beat the MMD double-A tax-exempt GO curve at 4.63%.
New York’s Metropolitan Transportation Authority and the New Jersey Turnpike Authority are also lining up to sell BABs in the coming days.
California is using a syndicate of 11 banks to sell its bonds. Goldman, Sachs & Co., JPMorgan, Barclays Capital and Morgan Stanley are the senior managers and book-runners.
They are targeting the sale to taxable bond buyers who don’t usually purchase California bonds, such as pension funds and foreign banks. Officials are hoping that will provide a new well of demand for the state to tap just six weeks after selling $6.5 billion of GOs in the tax-exempt market.
“California has some huge infrastructure investment needs,” Dresslar said. “This new product provides a way to diversify the investors and get a good deal for taxpayers.”
The state is doing an Internet road show and one-on-one calls with investors to drum up interest in the sale, but it will forego its usual retail push. The treasurer won’t run newspaper or radio ads in the state, Dresslar said.
Accessing a different market requires some changes from the typical municipal bond offering. The taxable market’s draw is its breadth and active secondary market.
The state’s underwriters said that means large deals with large bullet maturities do better in the taxable market. California’s BABs are expected to have bullet maturities in 2034 and 2039. Big bullets make for the formation of a more liquid and efficient secondary market in the bonds.
The long-dated maturities also allow the state to maximize the benefit of the BAB subsidy. With rates higher at the long end of the yield curve, the spread between the subsidized BAB rate and the exempt rate becomes more and more valuable at the long end.
The result is that the state will have to manage its debt profile around that future spike in debt service. That means upcoming tax-exempt deals will have to be front-loaded to balance the big, long-dated BAB maturities.
Dresslar said the bullets, while large, are “fairly insignificant” in relation to the state’s outstanding debt. California has about $48 billion of general obligation bonds outstanding.
The BABs garnered the same rating as the outstanding general obligation bonds, which were downgraded to the lowest level among U.S. states during California’s rolling budget crises of the past year. The GOs are rated A2 by Moody’s Investors Service and A by Fitch Ratings and Standard & Poor’s.
Given a large backlog of authorized-but-unissued California GOs, Moody’s said the state should be able to smooth out its debt service profile over the next few years despite the bullet maturities.
Taxable investors also expect different call protection. Municipal bonds typically care 10-year par call provisions, but corporate bonds usually carry “make-whole” calls. Make-whole calls recognize the fact that bonds might be worth more than par when they’re called. Municipalities usually call bonds to refund them when rates fall, which is when the bonds are worth the most.
California plans to give investors a make-whole call based on a formula that includes U.S. Treasury rates at the time of the call and an agreed-upon spread, according to the state’s preliminary official statement. That’s likely to make calls or refunding more expensive, but it should help make the bonds palatable to investors and garner lower rates up front.
Like other issuers, California chose to take the direct 35% subsidy to keep the deal simple for investors. To investors, the BABs are straight taxable debt and don’t require any extra paperwork. The state will collect the federal subsidy from the Treasury twice a year.
Local governments and bond lawyers have been debating the risk that the Congress would fail to appropriate money for the subsidies in future years, which would be an added risk for BAB issuers. California and its bond counsel believe the subsidy is fairly assured.
“The subsidy payment is equivalent to payment of tax refunds, and federal law gives the Treasury a continuous appropriation to pay tax refunds,” said bond counsel Robert P. Feyer of Orrick, Herrington & Sutcliffe LLP in San Francisco. That means the Congress would have to pass a new law to block the payments, which would undermine bond issues around the country.
He said the new structure also poses a curious problem for issuers and bond counsel because counsel don’t give investors a legal opinion on the tax-exempt status of the debt. Instead, they have to give the issuer some sort of assurance that the bonds are eligible for the BAB program.
Orrick and the state are still deciding the exact form of that assurance. The state wants to be sure that the bonds are eligible for the BAB program and that the subsidy won’t get cut off on them down the road.
Feyer said the BABs will be useful to issuers, but won’t completely replace tax-exempt debt. Unlike tax-exempt debt, BABs can only be used for construction, issuance cost, and funding a debt service reserve fund. They can’t be used for purposes like land acquisition and cash-flow borrowing.
