Buy Side

BAB Expiration Could Have Upside

NOV 11, 2010 6:15pm ET
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Many investors think the expiration of the Build America Bond program would actually be good for existing BABs because the entire universe of taxable bond buyers will be fighting over a finite and relatively small pool of available debt.

State and local governments are hurrying to float BABs while they still can. The federal stimulus program is set to expire at the end of the year unless it is renewed by Congress, which looks less likely given the Republican sweep.

BAB spreads blew out in the spring and have remained wide as the market frets over a supply glut to close out the year.

Now, investors have begun to consider how the $160 billion of BABs that have been issued so far will fare if the program sunsets at the end of 2010. While it is not obvious how existing BABs would respond to the expiration, many investors agree that two things will happen.

One is that demand for BABs will wane. With no new issuance, institutional investors that buy taxable bonds will not bother to build up staffs of analysts to follow BAB credits. It could be hard to get trading desks to pay as much attention to or make markets in outstanding BAB issues.

The second is that BABs will become scarce. With no new issuance, all the taxable bond mutual funds, pension funds, insurance companies and foreign investors who might want to buy BABs will be scraping for a limited supply in the secondary market — especially for sizable issues eligible to be included in taxable credit indexes.

The question is, which of these two forces will overwhelm the other? Will the curtailment of demand for BABs doom the debt class to wallow in illiquidity and wider spreads as an orphaned product? Or will the scarcity of BABs outstrip the reduction in demand, leading to tighter spreads?

“Demand would diminish if they’re not extended, but the question is, would demand diminish as much as supply?” said Peter Coffin, founder of Breckinridge Capital Advisors. “My argument is that it wouldn’t. … Demand would diminish, but I don’t think it would diminish as much as supply.”

Breckinridge manages $13 billion of municipal bonds, including $600 million of taxable debt.

Though the expansion of the buyer base for taxable municipal bonds spurred by the BAB program would likely halt, Coffin said, demand would not disappear.

The world of investment vehicles devoted to BABs is not huge, but it does exist.

And the taxable bond fund management industry is enormous. Taxable bond mutual funds alone hold more than $2.1 trillion of assets. Coffin said this industry has been slow to embrace BABs, mostly because they don’t have much experience with munis and don’t see much point in developing that expertise for a minor asset class with a imminent expiration date.

Nonetheless, these funds typically ­manage to a benchmark index, and BABs have begun to claw their way into taxable indexes.

A big buzzword in the BAB sector the past few months is “index-eligible.”

BABs that are part of an issue of $250 million or more are eligible for inclusion in the Barclays Capital U.S. Long Credit Index, which is the standard benchmark index for long-duration taxable portfolio managers.

More than 10% of that index is now taxable municipal bonds. That means passive managers have to buy taxable munis, and active managers have to at least consider it. BABs eligible for inclusion in the index typically enjoy greater liquidity and better pricing, market sources say.

Account managers will still be able to use BABs to meet their benchmarks even after the program expires. In fact, because BAB spreads are so fat, managers could use BABs to beat their indexes.

The average BAB yields 6.1%, according to a Wells Fargo index tracking the sector, which is 88 basis points more than the average long-term corporate bond yield indicated by a Moody’s Investors Service index following double-A rated corporate debt. That means a taxable manager could likely beat his benchmark by stocking up on BABs.

It was not always the case that one could generate higher yields by populating a portfolio with taxable municipal bonds.

John Hawley, a portfolio manager with Aviva Investors, pointed out there was a time when taxable municipal yields were lower than comparably rated corporate yields: before BABs.

The market used to recognize that taxable municipal yields warranted a premium for poor liquidity and a discount for superior credit quality, Hawley said. On balance, that meant corporates traded at spreads to taxable municipals.

The Barclays Credit Index yield 134 basis points more than the 20-year Treasury at the end of 2006. The taxable muni index of comparable maturity, yielded 70 basis points more.

BABs didn’t change this calculus in any fundamental way, except that they invited almost $100 billion of new issuance annually into an industry that was accustomed to about $25 billion of taxable municipal bond sales a year.

The supply influx has pushed spreads on taxable munis up, Hawley said. The disappearance of new BAB supply would likely pull them back down.

Hawley believes that once this new supply has abated, spreads will tighten again. Like Coffin, Hawley believes BABs — even orphaned BABs — are still appropriate investments for accounts that need long-duration taxable exposure.

“There’s a demand for high-quality long-duration assets, and BABs fit that very well,” he said.

The municipal team at Citi, which is led by George Friedlander, foresees a “segmented” market in the event the program lapses, according to their latest weekly report. They think big, recognizable names will benefit, while lesser-known names will underperform.

Domenic Vollena, who writes the BAB scales for Municipal Market Data, said investors are already ferreting out the well-known and index-eligible from the ones that might suffer greater illiquidity post-expiration.

He noted a triple-A Georgia BAB maturing in 2021 trading this week at a spread of 94 basis points over comparably dated Treasuries. By contrast, Baltimore County, which is also rated triple-A but is not as well-known, traded at a spread of 110 basis points.

“You’re going to start seeing a supply drought for those larger players looking for size,” Vollena said. “They’re going to want all the index-eligible paper.”

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