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MSRB: Be Aware of BAB, Other Direct-Pay Redemption Provisions

The Municipal Securities Rulemaking Board is urging investors and dealers to examine the redemption provisions of Build America Bonds and other direct-pay bonds so they can determine if the bonds’ market value could be affected by a redemption stemming from a sequestration-mandated cut in subsidy payments to the issuer.

“In some cases, issuers of the bonds may have the right to redeem the bonds under certain extraordinary redemption provisions that should be analyzed carefully,” the board said in a release and notice explaining the concerns.

In some cases, bond documents contain “make whole” provisions requiring issuers to call the bonds at a significant premium over par so that bondholders do not suffer losses.

The board also warned dealers that under its Rule G-17 on fair dealing and other rules, they are required to provide investors with all material information about direct-pay bonds, to trade these bonds at fair prices, and to make suitable investment recommendations to investors.

“Dealers and other financial professionals must not assume that individual bonds have the same redemption features or pricing characteristics as other bonds of the same type,” said MSRB Executive Director Lynnette Kelly. “Dealers must know the material features of the bonds they trade.”

The MSRB’s notice comes as several issuers have either taken steps to redeem BABs or other direct-pay bonds because of a reduction in subsidy payments or have filed notices on EMMA stating they believe their extraordinary redemption provisions would allow them to redeem bonds if they choose to do so.

Besides BABs, direct-pay bonds include Qualified School Construction Bonds (QSCBs), Qualified Zone Academy Bonds (QZABs), New Clean Renewable Energy Bonds (New CREBs) and Qualified Energy Conservation Bonds (QECBs), where the issuer elected to receive a federal subsidy payment from the Treasury Department.

The subsidy rates vary. For BABs the federal subsidy rate is 35% of interest costs. For New CREBs and QECBs the subsidy rate is 70% of interest costs. The subsidy rate of QSCBs and QZABs is the lesser of the actual interest rate on the bonds or the tax credit rate.

As a result of sequestration, the across-the-board federal budget cuts that took effect beginning March 1 and will run through the rest of the fiscal year ending on Sept. 30, Treasury had to reduce the subsidy payments it makes to issuers of these bonds. The Internal Revenue Service estimated the reduction in subsidy payments would equal 8.7%.

While the reductions in subsidy payments resulting from sequestration directly affect the issuers of direct-pay bonds, they also can affect investors buying, selling and holding these bonds, depending on the terms of the bonds and the redemption provisions in offering documents, the MSRB said in its notice.

The board urged dealers and investors to use its free EMMA website to access the official statements and other disclosure information available for direct-pay bonds.

“Investors need to understand the specific terms of any direct-pay bonds they are considering buying, selling or holding,” said Kelly. “Before making any investment decisions about direct-pay bonds, consult the official statement and other documents available on the EMMA website and speak with our investment professional to ensure you know the facts about when and how the bond could be redemmed by the issuer.”

The MSRB noted that dealers have fair pricing duties under its Rule G-18 for agency transactions, and G-30 for principal transactions, as well as suitability duties with respect to recommended transactions under its Rule G-19.

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