It is impossible to tell the story of the first half of 2009 in the municipal market without pointing to the creation of the Build America Bond program.
Since the program’s inception, taxable BABs have taken the municipal market by storm, with $15.56 billion of bonds sold in the first half of 2009, roughly 8% of the $196.72 billion of bonds that were priced in that period — and that’s despite the first BAB deal not hitting the market until April 15. The 148 BAB issues that were priced in the first half was close to 3% of the 5,541 issues priced in the muni market over the same period.
Created under the American Recovery and Reinvestment Act in February, the BAB program allows muni issuers to sell taxable debt in 2009 and 2010, choosing from one of two options. The issuer can receive a cash subsidy from the federal government or the bondholders can receive federal tax credits. The subsidies and tax credits are equal to 35% of the interest paid on the bonds.
Market participants had their concerns about the program when first enacted, largely in terms of its ultimate effect on the tax-exempt market, but after several months, many participants, including Loop Capital Markets managing director Chris Mier, are viewing the program as positive.
“BABs have been absolutely terrific,” Mier said. “As much as I thought they would be widely used and helpful to the market, their impact has been even greater than that. The existence of BABs is giving issuers much greater flexibility, and they’re providing issuers with the assurance that they’re going to be able to get their debt sold. It’s taken a lot of pressure off the traditional tax-exempt market. That market has done quite well, with rates coming down, prices going up, so I think it’s just been an absolute success.”
Mier said that, while it’s true BABs have eaten into tax-exempt issuance, it’s questionable whether any issuers who have come to market with them would have not come to market if BABs didn’t exist.
“I don’t see any strong evidence that there’s been a lot of that,” he said. “There might be one or two issues like that, but the vast majority of these issues were going to come anyway, even if BABs didn’t exist. So what I think you’re going to see is a continuation of BABs at or maybe slightly higher than the current run rate or percentage rate, and you’re going to see a proportional reduction in tax-exempts.”
Meanwhile, Phil Fischer, head of municipal strategy at Bank of America-Merrill Lynch, noted that the variable-rate demand obligation market “is basically gone, advanced refundings are very limited, but general purpose issuance is way up, so why would that category be rising so much in the face of the BAB issuance?”
“It’s because the BAB issuance is not in any sense crowding them out, it’s simply supplying a new source of capital into the muni market, and other credit demands in munis are absorbing the incremental supply of credit,” Fischer said. “Munis price very cheap on the long end, and we should not disregard that. If we had an adequate supply of capital coming into the tax-exempt coupon market, we would have tax efficiency on the long end of the market, but we don’t.
“These things price at or higher than equivalent Treasury yields, so clearly we don’t have an efficient market, there isn’t active arbitrage bringing in additional sources of capital, and so the BABs program has supplied a source of funds to the muni market that were exogenous to traditional muni issuance. So I read the BABs as being incremental to the amount of supply in tax-exempt coupons that we would have otherwise had.”
The BAB program kicked off in April, with $7.86 billion of debt sold over 17 issues, accounting for about 21% of the $36.78 billion issued that month. In May, there were 41 BAB deals for $2.7 billion, about 9% of the $30.53 billion priced that month, but in June, BAB issuance climbed to nearly $5.00 billion over 90 issues, accounting for almost 12% of the $43.86 billion issued that month.
Through the end of June, $5.87 billion of general-purpose BABs have been issued, which leads all sectors in terms of volume, though its 37 issues trails the 63 education BAB deals worth $2.58 billion that have come to market.
Howard Mackey, president of the broker-dealer business unit of Rice Financial Products, said that the BAB program has been a positive for the entire market, because a lot of the underwriters that have been involved in tax-exempts are also involved in underwriting BABs.
“As far as tax-exempt buyers are concerned, what you will have is basically a more competitive market in terms of lower yields on tax-exempts over time, because of the issuance of taxable bonds,” he said. “You’ll have somewhat of a scarcer supply as we go into the end of the year. Assuming the general tone in the fixed-income markets holds, you’re going to probably see the tax-exempt market actually outperform the general fixed-income market, just because of that dwindling supply.”
Faye Boatright, a managing director at Rice Financial, added that the BAB market has “allowed tax-exempt issuers to access a larger investor base, with pension funds and corporate bond funds being able to buy municipal credits, which pension funds don’t buy because they don’t get the tax benefit, and which corporate bond funds may have bought a small portion of in the past.”
“So you have a whole new investor base for tax exempt bonds,” she added. “And I think that’s positive for these investors to gain access to the value of an asset class which in general has lower default rates and is a higher credit quality investor base, based on some of the losses they may have had with some of the corporate credits from the credit crisis.
“And if you look at the list of issuers, it’s fairly broad, so you have small issuers accessing the market — school districts in Kansas and Kentucky — and then you have the traditional large cities and states accessing the market. So I think from that perspective, it’s been a good thing in terms of all types of municipal issuers being able to access the taxable investor base.”
Aside from BABs, overall volume for the first half dropped 15% from last year, to $196.72 billion in 5,541 issues from $231.51 billion in 6,200 issues in the first half of 2008.
George Friedlander, muni strategist at Morgan Stanley Smith Barney, said that “the severe shortage of access to the variable-rate market” in the first half of this year was also “a very big deal.”
Total variable-rate issuance dropped 73% in the first half of 2009 from the same period in 2008, to $21.72 billion in 400 issues from $80.01 billion in 1,211 issues last year.
“Even though issuance was off, tax-exempt issuance was off, fixed-rate issuance was up dramatically because variable-rate issuance was off so much,” Friedlander said.