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Build America Bonds

Scarcity Value Gives BABs a Boost

When the Build America Bond program ended there were two schools of thought. One argued that BABs would become an orphan class, with prices in the secondary market suffering from illiquidity. Another group thought there would be some scarcity value to the product and they would appreciate in value.

The scarcity camp won, according to Mike Pietronico, chief executive officer at Miller Tabak Asset Management. Scarcity has kept demand for BABs high and played a role in pushing yields lower.

“The bonds have been appreciating and outperforming,” Pietronico said. “To the extent that they’re offered for sale by clients or customers who own them, there will be a continued good demand for the securities just because of the scarcity value.”

BAB yields have indeed fallen. Since the program ended, a Wells Fargo index tracking BAB yields reached a high of 6.49% on Feb. 8. But the index’s yields have plunged 101 basis points to 5.48% as of June 1.

Over the same period, yields for 30-year Treasuries have tightened 61 basis points from their high of 4.76% on Feb. 10 to a calendar low of 4.15% on June 1, according to Municipal Market Data. And 30-year triple-A muni yields have plummeted 82 basis points from their high of 5.08% on Jan. 14 to 4.26% on June 1.

Demand for BABs, predominantly a long-term product, varies along the curve. As there is scant supply inside 20 years, those bonds trade fairly aggressively, said Robert Novembre, a managing director at Arbor Research and Trading.

As one moves further out the curve, there is still value to be found against comparable corporate debt. But some accounts have become wary about chasing BAB prices higher, according to Novembre.

“There’s some hesitation there,” he said. “An indication that the market is getting a little bit toppy is that we’ve seen a couple index-eligible BAB positions, which typically fly off the shelves, get a little stale.”

A Short History

The BAB program traces its roots to the American Recovery and Reinvestment Act in February 2009, which authorized municipalities to sell taxable bonds and collect a federal subsidy equal to 35% of the interest cost. The program expired in less than two years. Still, it generated 2,354 issues and $181.5 billion of debt before it ended, according to Thomson Reuters data.

What’s more, it changed the municipal market on the long end. By granting easier access to the taxable market, BABs and their federal subsidy gave municipalities a way to significantly lower their borrowing cost for long-term debt. Subsequently, a large amount of municipal debt issuance shifted from the tax-exempt market to the taxable market.

As the sun started to set on the program, state and local governments pumped up the supply by selling a whopping $133.6 billion of bonds, much of them BABs, in the fourth quarter, leading to a record $433.1 billion in total municipal bond issuance for 2010.

The combination at the long end of massive supply and uncertainty about the future level of demand pushed yields higher. The 30-year triple-A yield rose 42 basis points in November and another 40 basis points in December.

Coming into 2011, the thinking went that yields would be higher this year and issuance would be lower. By the end of February, the 30-year yield was about 50 basis points higher than it was at the end of February 2010.

Rates had been pushed higher by several factors. The expiration of the BAB program forced issuers to sell mainly tax-exempt bonds, raising concerns about the market’s ability to absorb the debt as Treasury rates backed up and headline risk dogged ­munis.

The end of BAB issuance stands as a large reason behind the decline in BAB yields over the year. But it isn’t the entire reason, according to Bedford Lydon, a senior fixed income analyst in the research department at McDonnell Investment Management. Long-term muni bonds, particularly 30-year, triple-A general obligations, have also seen a substantial decline in yields.

“Part of the decline could be tied to muni yields, in general, and part of it could be the BABs” expiration, he said. “I think it’s a bit of both.”

Buyers of BABs in the secondary market have been encouraged by the product’s scarcity bid. The buyers vary, from small to large investors.

Miller Tabak’s Pietronico said buyers include institutions that currently own some BABs and are looking to add to their holdings in the sector whenever there’s any secondary market float.

Dan Loughran, who heads the Oppenheimer Rochester municipal investment team as a senior portfolio manager of OppenheimerFunds Inc., agreed. From what he hears from the Street, buyers comprise the same long-term investors that were interested in the BAB program in the first place, because of their relative value compared with other taxable fixed-income ­alternatives.

Early BAB investors have gotten a good deal thus far.

When the Metropolitan Transportation Authority of New York issued $750 million of BABs on April 23, 2009, the bonds came at par and offered a yield of 7.34%, a spread of 354 basis points above Treasuries, according to Thomson Reuters data. The deal was rated AA by Standard & Poor’s.

On June 3 this year, the bonds were trading in the area of 124 and the yield was down to 5.64%. The spread to Treasuries had tightened to 133 basis points.

Will They Return?

Before the Build America Bond program ended on Dec. 31, there was a drive to extend it, but that didn’t happen. Today, conversations on Capitol Hill revolve around new programs that would be similar to BABs, but with smaller government subsidies.

Rep. John Tierney, D-Mass., said he would introduce a bill requiring all new munis to be taxable direct-pay bonds with a 25% federal subsidy rate.

Issuers and underwriters have longed for the reinstatement of the BAB program since Congress let it expire. But several market participants say Tierney’s proposal takes the wrong approach: a 25% subsidy rate and the abolition of tax-exempt bonds would unsettle a market that’s already battling negative headlines and paltry ­issuance.

There have been at least four bills that have been introduced in the House to renew BABs. They are all sponsored by Democrats and include subsidy rates of between 28% and 32% in the first year. None of the bills seeks to eliminate the tax-exempt status for new municipal debt.

A six-year transportation reauthorization bill being drafted by Rep. John Mica, R-Fla., might contain a version of BABs to be used exclusively for transportation.

In the Senate, Ron Wyden, D-Ore., introduced tax-reform legislation that would require new munis to be tax-credit bonds instead of tax-exempts. Wyden also is considering tax-credit bonds for transportation projects.

As tax reform will be a key component of whatever deficit-reduction package is ultimately agreed to on Capitol Hill, it will also play a role in any possible return of the BAB program, according to Chris Mauro, a research analyst at RBC Capital ­Markets.

“We expect that there’s going to be some impact on the municipal market, whether that means you get something like a Tierney proposal, or whether you get some restrictions on issuance and a narrowing of the definition of what an allowable purpose for tax-exempt financing is,” he said of Washington’s tax reform plans.

“Our view is the latter: we’ll get more restrictions on what we can do if tax reform is enacted.”

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