Attempts to Bolster Munis Could Hinder BAB Demand, Report Says

Any legislative attempts to boost the traditional tax-exempt bond market, as well as hikes to the top tax rates, could drive down demand for new tax-credit Build America Bonds, a Congressional Research Service report released this week said.

In a 17-page report outlining for members of Congress the various tax-credit bond programs, Steven Maguire, a public finance specialist at CRS, said that "congressional action that would enhance the traditional tax-exempt bond market," including passing a law creating a federal guarantee of municipal debt, could drive down demand for BABs. The report was dated April 16.

House Financial Services Committee chairman Barney Frank, D-Mass., is currently drafting an omnibus bill to aid the muni market that may include, among other items, a federal guarantee of general obligation debt or some type of federal liquidity facility for variable-rate demand obligations, though congressional sources said this week that he may be reconsidering the GO guarantee component.

Still, Maguire noted that demand for tax-credit BABs - taxable debt muni issuers sell that provides investors with a tax credit equal to 35% of the interest costs - could also fall if the marginal tax rate rises.

Currently, the top marginal tax rate is also 35%, equal to the subsidy rate for direct pay BABs. As a result, top wage earners can realize as much of a benefit from taxable BABs as tax-exempt debt.

But if the rates were increased, tax-exempt debt becomes more attractive to those investors, since the exemption always will provide maximum tax benefit, while the BABs are capped at 35%.

In the budget outline released in February, President Obama proposed letting the tax cuts put in place by President George W. Bush for the top two tax brackets expire, returning them to 36% and 39.6%, respectively.

However, allowing the cuts to expire rather than actively instituting higher rates means the tax hikes will not come until 2011. The BAB program is scheduled to sunset at the end of 2010.

Maguire added that since BABs are a brand-new financing tool, it was unclear how market participants would receive it.

"Both parties may be unwilling to use an untested, nontraditional method to finance government activities," he wrote. "In addition, the relatively short window for issuers to sell BABs, which expires after 2010, may limit investor interest."

But thus far, BABs have seen strong interest, primarily among large states and toll roads. California is in the process of selling at least $5 billion of BABs, and more recently, the North Texas Tollway Authority said it was considering issuing up to $500 million of BABs.

And most issuers are looking at the "direct pay" option for their BABs, where instead of a tax credit to investors, the issuers receive a 35% cash subsidy.

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