WASHINGTON — Federal lawmakers and their staffs are wrong to think that tax-credit bonds could cost-effectively replace tax-exempt municipal bonds as a source of financing for state and local governments' projects, Citi said in a recent report.

Citi issued the seven-page research report after Senate Finance Committee chairman Max Baucus, D-Mont., last month called for Congress to consider alternatives to tax-exempt bonds to promote uniform subsidies for bondholders and after a Congressional Budget Office official claimed tax-credit bonds would be a better alternative to tax-exempts.

Testifying at a hearing, the CBO official said some analysts suggest that only about 80% of the tax expenditures from tax-exempt bonds turns into lower borrowing costs for states and localities, while the remaining 20% is transferred to bondholders in higher tax brackets. In contrast, he said, the lost federal revenues from tax-credit bonds are entirely captured by states and localities.

In addition, legislation introduced by Sen. Ron Wyden, D-Ore., that could end up in the transportation bill currently being negotiated by House and Senate conferees would authorize $50 billion over six years for tax-credit bonds to be used for transportation projects.

But Citi said that tax-credit bonds are not really understood and have "severe shortfalls." The report, authored by analysts George Friedlander, Mikhail Foux and Vikram Rai, provides a primer on how tax-credit bonds work. The total income to investors from a new tax-credit bond would consist of a taxable coupon and a taxable tax credit.

If a 20-year tax-credit bond yielded 5% and the tax credit rate was set at 28%, the investor would receive taxable coupon income of 72% times 5%, or 3.60%. The investor would receive a tax credit, payable over the life of the bond equal to 1.40% of principal. The reduction in the investor's income tax paid resulting from the tax credit would be treated as taxable income, taxed at the investor's maximum marginal rate, they said.

In order for tax-credit bonds to work, they would have to be "strippable," the analysts said. The issuer or underwriter would have to be able to strip and separately sell the tax credit from the coupon, because the credit would be attractive to only some investors.

The most likely buyers of the taxable coupon bonds would be institutional investors that pay little or no taxes and already buy other taxable bonds. Those investors include pension funds, foreign investors and life insurance companies, the analysts said. But since they pay no tax on ordinary income, they would have no use for the tax credit, with the possible exception of insurance companies, they said.

In contrast, the most likely buyers of the tax credit would be investors who pay substantial income taxes and would want the credit to offset their taxable income.

The analysts said Citi's studies have shown "that there is scant demand for long-term bonds that pay a fully taxable tax-credit relative to the strong demand for long-term fully taxable instruments. Indeed, at this point in the interest rate cycle, there is scant demand for long tax-exempt bonds from individuals as well, and these investors, presumably, would make up a very large proportion of the universe of buyers for the tax credits."

"Enticing such investors into long-maturity complex instruments such as stripped taxable tax credits would clearly require a very high discount rate on this component of the original issue," the report said.

The report said the strippable tax credits would often be tiny in size and would have to be priced with a very substantial premium.

The presumption that tax-credit bonds would "level the playing field" by ensuring all potential investors, regardless of their tax bracket, would get the full benefit of the credit, is simply incorrect, because the taxable coupon portion of the bonds would be most attractive to entities who pay taxes at low rates and who pay no taxes on ordinary income, the analysts said.

The report also rebuffs claims that tax-credit bonds have not been welcome in the muni market because of their limited size and the absence of rules governing stripping.

"In our view, this conclusion is simply incorrect. 'Strippability' would not overcome the massive complexity and liquidity problems associated with selling small pieces of annual tax credits along with small pieces of coupon income and a large amount of principal," the report said. "Nor would it create the larger demand structure for taxable tax credits needed to allow them to be priced at yield levels close to those on corporate bonds."

The benefits to tax-credit bond issuers would decline proportionately with any extra yield issuers have to pay to clear the market, the report noted.

Also, if the amount of outstanding tax-credit bonds were to grow over time, the price, in discount rate, required for a small set of potential investors to clear the market, would be likely to skyrocket, according to Citi's analysis.

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