Congress has potentially changed the structure of the tax-exempt bond market by creating a taxable Build America Bond program that will likely be continued and expanded, thereby limiting the use of tax-exempt bonds for short-term and other specific kinds of financings, a University of Miami law professor claimed yesterday.
“I don’t think that anybody really thinks there was a conspiracy to eliminate tax-exempt financing,” Stanley Langbein said during a teleconference sponsored by the American Bar Association’s committee on tax-exempt financing and section on state and local government law. “But we’ve already seen in the market that the presence of Build America Bonds cuts down the supply of ordinary of tax-exempt bonds.”
Langbein said BABs provide issuers with cheaper borrowing, and underwriters and institutional investors like them because they can flip them — that is, buy them and immediately sell them at a higher price to retail investors. As a result, he said, there is pressure from all market participants to expand the BAB program.
“That will constrict the supply of tax-exempt financing, which will still prevail but in limited circumstances like short-term financing,” he said.
“No one believes that Congress is going to do anything to tax-exempt bonds,” Langbein said. “But Congress rather quickly adopted this program and it has the potential and almost the inevitability to change the structure of the municipal market.”
The professor’s remarks came after John Buckley, majority chief counsel for the House Ways and Means Committee, scoffed at the concerns of some market participants that the creation of BABs was a conspiracy by Congress and the Obama administration to kill the tax-exempt bond market.
Buckley said that Congress, without any involvement of the administration, created the new tax-credit bond and BAB programs in the American Reinvestment and Recovery Act because “it wanted to assist state and local governments at a time when they were facing a terrible market for traditional tax-exempt bonds.”
“Tax-advantaged investments were out of style at the beginning of the year” because of unprecedented turmoil in the financial markets, he reminded the lawyers.
Tax-credit bonds were developed as an alternative to direct credits with the aim of providing more certainty than the appropriations process, he said. They will likely “be a niche market” and are “not at all intended or expected to be a substitute for traditional state and local bond financing,” Buckley said.
BABs “were intended to improve and expand the market for state and local governments,” to allow them to access to tax-indifferent investors to borrow money,” he said.
Buckley acknowledged that there have been questions about the pricing of BABs, which initially had much higher yields than corporate bonds with similar maturities and credit ratings. “That spread has fallen dramatically over time,” he said, citing four reasons for why it still exists somewhat.
“First, there is the novelty,” Buckley said. “There is always a discount for a new product in the market until investors become comfortable with it.” Also, BABs do not yet have enough volume or liquidity for the secondary market. “There is a little liquidity discount but that could disappear over time,” he said.
Another reason for the spread is that BABs have been issued with some of features common to the tax-exempt market, but not the taxable market, such as calls, and “there’s been a price paid for that,” he said.
An unanticipated fourth reason, he said, is the ability to take advantage of the spreads between BABs and corporate debt, which cannot be done in the traditional tax-exempt bond market because of the tax code’s section 265 interest disallowance rules. Under those rules, banks and other institutions are restricted in the amount of tax-exempt bonds they can buy without having to worry about have their interest deductions disallowed. But those rules do not apply to BABs.
Buckley said that as long as BAB rates remain higher, investors can borrow at the corporate rate and invest in the BAB rate.