BABs-like product would expand bank, foreign investment in munis

The return of direct-pay bonds would increase bank and foreign demand, create municipal hedging opportunities and expand the liquidity pool for a market that sorely needs it.

A persistent and substantial supply of taxable munis, with a new Build America Bond-like tool, over time would likely result in a change in the makeup of the muni buyer base, according to a report by Morgan Stanley & Co. strategists.

Taxable munis fit the need for high-quality duration and asset-diversification for banks, increasing the institutional holdings, they said.

Taxable munis via a BABs-like instrument could fit the overseas demand for U.S. dollar-denominated debt and “potentially demand for fixed-income more broadly given excess yield on a currency-hedged basis,” they said.

Further, taxable munis are simply more easily hedged than their tax-exempt counterparts, “further encouraging institutional participation."

All of this depends on Washington actually bringing back the taxable product and making it a permanent program.

It also would require a higher permanent subsidy rate, 28% at the very least most participants say, to make them worthwhile for issuers.

The likelihood of a direct-pay bond program being enacted in 2021 is significantly diminished since it was not included in the infrastructure package working its way through Washington. It now can either be included in a Democrat-led budget resolution or a stand-alone bill.

The expected reconciliation bill, a massive "social infrastructure" agenda unlikely to win any Republican support, is where many market advocates are now hoping direct-pay bonds appear.

While it is possible to authorize a new bond program by a stand-alone bill, which already exists, it is historically much more effective for such provisions to ride on larger spending packages.

There is little question that adding another tool such as direct-pay bonds would expand the investor base for munis. Back when BABs were introduced to the world, investment firms did world tours touting the product. Issuers sold $180 billion of the bonds in less than a two-year window when they were legal, setting the stage for the ease with which issuers were able to market taxable refunding paper the past two years.

Taxable municipal bonds now make up nearly 30% of issuance since the onslaught of the product began in mid-2019.

Last year's record $480-plus billion of issuance was 30% taxable. In 2009-2010, taxables including BABs made up nearly 36%.

About 73% of munis are owned by individuals, either directly 44% or by proxy (mutual funds) 28%. That means institutional and overseas investors account for only 27% of muni ownership, Morgan Stanley noted.

"Over time, we’d expect institutional and foreign ownership to trend higher toward that of the market whose characteristics would be its closest proxy: investment grade corporate credit," the report said. "We think taxable munis could become an attractive option to banks and foreign investors, reinforced by potential development of new muni derivatives and hedging market."

Morgan Stanley predicts that if BABs were a permanent part of the market, taxables would overtake tax-exempts by par amount, leading to $880 billion over a five-year period, if the subsidy were equal to 35% as they were in 2009-2010.

Direct-pay bond provisions introduced in the past few years have included a promise that the subsidies would be unscathed by a sequester-like event. BABs subsidies are subject to a sequestration rate of 5.7%, which the Internal Revenue Service said will affect all payments until 2030 unless and until legislation changes the situation.

If direct-pay bonds return, those expanded demand components would greatly expose the municipal market to a much larger pool of capital.

A few of the knock-on effects of the permanent program would be "attention and expertise." Morgan Stanley says benchmark-size taxable munis outstanding are only a modest $474 million, or 1.8% of the Bloomberg USD Agg Index.

“Given this size, it is difficult for overseas institutional investors to justify dedicating resources to trade execution and credit analysis for the market," they wrote. "We expect this would change as the market grows, with overseas expertise building over time, enabling more reliable demand for the the product."

Significant growth in the taxable market by way of a permanent BABs program would expand the opportunity for hedging muni exposure, with exchange-traded funds potentially leading the way, according to Morgan Stanley.

While institutional investors want a hedging tool for munis, the opportunity is typically blunted for a variety of reasons, the strategist said.

An investor shorting the tax-exempt market took on basis risk given the mismatch between the tax-exempt muni coupon and the taxable payment of the hedger, the report said. An investor shorting the taxable market paid higher costs given its small size, making it difficult of costly to locate and instrument to short (i.e. cash bonds or ETFs).

"While robust growth in the taxable market via a new BABs wouldn’t solve the problem of hedging tax-exempts it could create new opportunities in the latter by boosting the size of the market and over time, more liquid, tradable products such as ETFs," they wrote.

For now, it's all a 'what if' scenario for the market as participants take the typical wait-and-see approach as negotiations continue in Washington.

The infrastructure package negotiated and agreed to by a bipartisan group of Senators and championed by the Biden administration, which does include expanded private activity bond authority, but not the reinstatement of advance refunding, or a new direct-pay bond program, awaits Senate approval.

The plan will likely get a vote and any 'reconciliation' Senate plan could be announced as soon as this week given Senate Majority Leader Chuck Schumer's stated desire to have a vote before the scheduled August recess.

However, "if BABs are not included in either, we'd likely then consider their comeback a long shot,” Morgan Stanley said.

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