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Stimulus

BAB Issuance Out of Balance

Issuers in four states have ­accounted for nearly half of the $164 billion of Build America Bonds issued since the ­program’s inception 19 months ago. Municipal market participants say the lopsided ­distribution should be a consideration for investors, but for others the unbalance has limited value in measuring the program’s success.

Created as part of the American Recovery and Reinvestment Act in 2009, BABs allow issuers to sell taxable debt and receive a 35% interest cost subsidy from the federal government. The program is set to expire at the end of this year. Congress is considering extending them for at least a year, perhaps at a lower interest cost subsidy level. Some critics of the program have pointed to the uneven distribution of the use of BABs as a weakness.

Issuers in California have been the largest borrowers by far, with 148 deals totaling $36.5 billion, or 22.2% of all BAB volume to date, according to Thomson Reuters.

The state has borrowed about a third of that total, while other borrowers within California have issued the bulk.

Issuers in New York have borrowed $18.1 billion, or 11% of all BAB volume. That means just two states make up almost one-third of all BAB issuance, a fact that prompted Dominic Frederico, chief executive of bond insurer Assured Guaranty, to tell investors at a conference call earlier this month that BABs are “a California, New York program and not a nationwide program.”

Issuers in Texas and Illinois have borrowed $15 billion and $10.8 billion, respectively.

The 48.9% market share constituted by these four states compares with their 35.8% share among tax-exempt issuance. This suggests that borrowers within states that frequent the market took advantage of the stimulus program more than others.

Bob Fields, product manager for municipal bonds at Pacific Investment Management Co., said it should be no surprise that larger issuers are more proactive in getting involved in the program, given their infrastructure needs. Borrowers who issue the most have more reason to put in the work to understand what is cost effective and what is not.

Justin Hoogendoorn, managing director at BMO Capital Markets, added that there is nothing inherent to the program that makes it more favorable to large issuers versus the traditional tax-exempt.

Bigger issuers can benefit more insofar as large deals are eligible for inclusion in taxable indexes, and that brings in more demand, Hoogendoorn said. But in other respects it doesn’t matter who is selling BABs, and who isn’t, because when larger issuers opt to issue into the taxable market, it leaves fewer tax-exempts on the calendar and drives those yields lower.

“The program very clearly had a downward impact on tax-exempt yields, so even for those issuers that weren’t taking advantage of the program itself, they were issuing at better levels because of it,” Hoogendoorn said.

When tax-exempt yields fell to all-time lows in late August, it was largely attributed to a scarcity of supply stemming from issuers using BABs.

California issued $3.3 billion of BABs into the taxable market on Nov. 19. If BABs were not an option, it could have been forced to issue tax-exempts. Hoogendoorn said that kind of surge in supply could have sent borrowing costs across the market soaring, well beyond the 45 basis point climb they did rise on the long-end this month.

That climb, too, was a result of BABs, Hoogendoorn said, because the looming expiration of the program means people are anticipating a lot more tax-exempt supply next year.

The yield spread between investment-grade BABs and double-A rated corporate bonds jumped to 117 basis points — up 38 basis points between Oct. 12 and Nov. 24 — according to data from Wells Fargo and Moody’s Investors Service.

“That’s the biggest argument to extend the program,” Hoogendoorn said.

In the early months of the program, the proliferation of BABs helped tighten credit spreads versus similarly rated corporate credits. But uncertainty about the program’s extension, coupled with the European sovereign debt crisis, has caused those same trends to reverse.

Chris Mier, head of analytical services at Loop Capital Markets, said states that have embraced the BAB program tend to influence the issuers below them, which has compounded the uneven distribution.

Mier noted that Florida and Iowa — two states that have expressed concerns about the program — have a smaller market share of outstanding BABs than they do for tax-exempts sold since April 2009, while the opposite is true for states like California and Illinois, which have embraced the program.

Borrowers in Illinois have issued more separate BAB deals than any other, with 224 issues totaling $10.8 billion, or 6.6% of all issuance. Its share of tax-exempt issuance from April 2009 to the present is 3.5%.

In most respects, municipal market participants say the impact of the unbalanced distribution of the BABs that have been sold is limited, as there is nothing prohibiting smaller issuers from accessing the market. Indeed, issuers in all but two states — Rhode Island and Montana — have taken advantage of the program, and the infrequent issuers tend to issue little debt in the first place.

However, the geographical distribution of BABs can play a role for investors who have regional restrictions within their portfolios as a way to diversify risk, said Peter DeGroot, head of municipal bond strategy at Barclays Capital.

Because different issuers within a state will rely on state revenue, or will share the same tax base, it can make sense to limit one’s exposure to a particular region. As a consequence, DeGroot said some issuers may face higher borrowing costs than similarly-rated credits in states where issuance is less frequent.

“Issuers in high-volume states often pay higher yields than similar-structure securities from states that tap the market less frequently,” he said.

Within the Barclays Capital Taxable Municipal Index, long double-A rated California credits — defined as maturing in 30 years or more — yield 28 basis points more than similar term double-A credits in the benchmark index from issuers in other states.

In the 28-to-30-year area of the curve, the double-A rated bonds from California issuers yield 25 basis points above the national index, according to DeGroot, who manages the index.

The market share dominance of the high-volume states can be more pronounced within indices designed to track BABs. DeGroot said minimum size and other eligibility requirements means about half of BAB issues are ineligible for Barclays’ indexes, and many of the excluded issues are from smaller borrowers.

The top five states account for 70.5% of the Barclays Capital Build America Bond index, which is widely used as a benchmark index. Issuers in California account for 26.9% of the index, Illinois makes up 16.1%, New York 11.6%, Texas 8.7%, and New Jersey 7.3%.

The geographical concentration of BAB issues needs to be taken into account by investors that benchmark their performance against an index, DeGroot said, because high market value concentrations tend to increase the relative attractiveness of the issuer’s bonds.

“Investors need to consider the performance implication of securities which have a meaningful impact on the performance of the benchmark,” he said.

If an investor gives less weight to a credit that is weighted heavily in the Barclays index, such as California general obligation bonds, and that credit tightens over time, the underweighted portfolio will lag the Barclays index.

Conversely, investors wanting to beat the benchmark may choose to avoid the over-weighted credits if they believe other securities will be less volatile.

Peter Demirali, taxable fund manager at Cumberland Advisors, said his firm largely avoids investing in debt from issuers in more problematic states such as California, Illinois, New York, and New Jersey. That gives his portfolio broader diversification and stronger credits, he said, because the less frequent issuers — like those in Maryland, Florida, or North Carolina — tend to be more fiscally prudent.

“If the construction of the index if 45% New York and California, you don’t want to have a greater beta,” Demirali said. “What you want to do is get some alpha, and that is buying states like Utah or Alaska when they come to market — states that are not typically issuers of paper, whether is taxable or tax-­exempts.”

That dynamic does not necessary help issuers, however. Demirali said issuers that sell debt less frequently tend to be priced at a concession when they come to the market, but in the secondary market they perform better.

Other investors disagree that geographical considerations should affect an investor’s decision when dealing with munis.

“Muni credits require one to analyze that specific issue or issuer itself, as ­opposed to in the corporate bond market where you tend to have sectors all moving in one direction,” PIMCO’s Fields said.

The Build America Bond Strategy Fund launched by PIMCO in September is slightly overweight versus the benchmark index from Barclays in its California holdings. Fields said that’s a result of credit analysis, combined with pricing comparisons against comparable BAB or corporate credits.

“Away from the credit decisions, do we intentionally not buy a security or actually buy a security strictly by its location? No,” he said. “Our decision is first and foremost a credit decision. … That’s a much bigger factor than what part of the country it’s in.”

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