However, few issuers would likely be able to call their BABs because most ERPs would not be triggered by the cuts to subsidy payments, the bank contends in a research report issued Thursday.
For now, if BAB ERPs are triggered, the calls would likely be too costly for issuers because they require issuers to “make whole” investors. The issuers would have to pay investors a premium to call the bonds.
The three analysts who wrote the report — Tom Weyl, Sarah Xue, and Ming Zhang — said investors have been asking Barclays about BAB ERPs, and have particularly wanted to know if they could be “cured” or stopped once triggered.
“Our reading of the various provisions leads us to conclude that once the conditions that trigger the ERP are met, the situation exists for the remaining life of the bonds,” the analysts wrote in the report. “However, there are several reasons why we think there is a limited risk in this regard.”
First, “an overwhelming majority ERPs will not be triggered by sequestration cuts,” the analysts wrote.
The analysts’ report was based on their review of the bond documents and ERPs of 188 Cusips, or different BAB maturities, totaling $85.5 billion par amount, in Barclay’s BAB Index.
Of the 188 Cusips, 156, or 83% of the par amount, had “weak” or “moderate” ERP language in bond documents. In addition, five Cusips or $1.4 billion par amount, had no ERPs at all.
As a result, the analysts wrote, a total of “86.2% of the Cusips, or 86.7% of par outstanding in the BAB index, have virtually no risk of being called based on the subsidy reduction found within the sequester.”
“As we have stressed for some time, it is all about the language” of the redemption provisions, the analysts wrote.
Weak ERPS would trigger calls only if there were material adverse changes in the federal tax law provisions that created and govern BABs. But the across-the-board cuts in federal spending are being made because of budgetary decisions and do not change the tax law.
Moderate-risk ERPs are similar, but also say a call would be triggered any guidance published by the Treasury Department or Internal Revenue Service reduced or eliminated the subsidy payment.
However, the BAB subside cuts were not decided by the Treasury or IRS, but rather Congress and the Office of Management and Budget.
The ERPs that pose the strongest risk of a call typically say BABs could be called if Congress, any law, a court, a ruling, or a regulation reduces or eliminates the subsidy payments.
However, Barclays contends that few issuers would want to call their BABs because of “make whole” ERPs that would require them to pay a premium to call the bonds. The investment bank found 182 Cusips or $83.8 billion of the par amount of BABs in its index had “make whole” ERP provisions. Only one Cusip for $300 million par amount of BABs, had a “par call.”
“As we have discussed in prior publications, the make-whole redemption price in these transactions renders the economics of a refinancing prohibitive,” the analysts said in the report. “However, if the redemption provision is triggered and never cured, this would create the risk that at some future time, the economics will work in favor of the issuer’s redeeming the BAB issue with tax-exempt debt.”
“Doesn’t this sort of cut both ways?” asked Scott Lilienthal, president of the National Association of Bond Lawyers and a partner at Hogan Lovells LLP here.
If interest rates go up for BABs, they also would likely up for any tax-exempt refunding bonds.
“The redemption premium has gone down but the [interest rates for the] new bonds you want to issue have gone up,” he said.
Lilienthal said that while “it’s certainly possible” that a BAB with a triggered ERP could be called anytime, “you have to be careful about jumping to conclusions” and “you have to fall back on the precise language of the [ERP] provisions.”
“Our No. 1 guidance is that it depends on the specific language, each issuer’s specific bond redemption provisions,” agreed Richard Moore, a partner at Orrick, Herrington & Sutcliffe.
Moore said “it’s not entirely clear” if BABs could be called over a period of years, based on the documents he’s seen. “If there’s a lot of money at stake, there often is enough ambiguity that the parties could expected [such calls] to be litigated,” he added.
Matt Fabian, a managing director at Municipal Market Advisors, said MMA agrees with Barclays that if the BAB ERPs are triggered, the BABs could be called anytime, even years later.
Several market participants said that issuers may not want to make investors angry with such calls, especially if they plan on issuing taxable bonds again.
But Fabian said underwriters may push for BAB calls.
“Investment bankers don’t get paid to not call bonds,” he said. “They do transactions. There’s an incentive for them to figure out a way to call bonds that are seemingly uncallable.”