Build America Bonds died Jan. 1 at the age of 22 months.
The taxable program was conceived as a part of the American Recovery and Reinvestment Act as a way to help stimulate a moribund economy. It is survived by its much older sibling, the tax-exempt municipal bond market.
The Build America Bond program was adopted by the U.S. Treasury, which provided issuers with a generous 35% direct interest subsidy or a comparable tax credit. Issuers were authorized to sell an unlimited amount of BABs in 2009 and 2010 under the program, with proceeds to be used exclusively for capital improvements.
The program proved to be far more popular than anyone expected.
Despite such a short life, the BAB program spawned 2,354 issues and $181.5 billion of debt before its midnight Jan. 1 expiration, according to Thomson Reuters data. Based on the average yield of 6.2% under a Wells Fargo index tracking BABs, that implies $11.25 billion in annual interest costs and $3.94 billion in annual subsidies.
In early 2009 the federal government thought the annual cost of subsidizing BABs would be $340 million. But issuers saw in the program a way to get subsidized financing for major projects.
“It was the right program at the right time for the right part of the yield curve,” said Michael Pietronico, chief executive officer at Miller Tabak Asset Management. “There’s hardly a place in the muni market you can look where people didn’t benefit from it.”
BABs first appeared in the market on April 15, 2009, when the University of Virginia and the University of Minnesota brought small transactions. The largest BAB deal of 2009 came just a week later, when California sold $5.17 billion of the securities.
In fact, the $37.8 billion of BABs brought to market by fiscally wounded California during the lifespan of the program was by far the most of any state — more than double second-place New York’s $18.6 billion.
California Treasurer Bill Lockyer in December hailed the BAB program as “a great success story.”
“It has helped finance critical infrastructure investment across the country, [created] thousands of jobs and saved taxpayers billions of dollars,” he said.
But the program’s very success helped sow the seeds for its quick demise. Heavy BAB issuance by the country’s largest, and in some cases perhaps most profligate, states made the stimulus bonds a target for those unhappy about what they saw as out-of-control federal spending.
“From a 10,000-foot point of view, the program seemed to benefit the larger states, East and West Coast in particular, and perhaps the middle of the country was uncomfortable with getting involved in underwriting their debt,” Pietronico said.
The top three states in terms of population — California, New York, and Texas — were also the top three in total BAB issuance. While the combined populations of those states make up just over 26% of the U.S., the three states combined for 46% of all BAB issuance.
The beneficiaries of the program lobbied to keep it alive.
On Feb. 1, 2010, President Obama proposed in his fiscal 2011 budget request to make the program permanent, but reduce the subsidy rate to 28%. That, it was claimed, would make BABs revenue-neutral.
Other proposals called for the program to be extended through April 1, 2013, with annually reduced subsidy rates. This would have dropped the federal subsidy to 33% in 2011, 31% in 2012, and to 30% for the first three months of 2013.
But in the end, the program’s supporters could not fight rising concerns in Washington about government spending. An extension for the BAB program was left out of a tax bill signed into law in late December. BABs were dead.
“In the beginning, I was predicting it would be extended in perpetuity,” said Chris Mier, managing director at Loop Capital. “Then with the run-up to the [November 2010] election, there was more emphasis on the cost of the program. What had been painted as a positive for economic growth was being re-characterized as bloated big government.”
Some Republican members of Congress, including Iowa Sen. Charles Grassley, the ranking minority member of the Senate Finance Committee, claimed BABs were a spending program disguised as a tax cut that mostly benefited big Wall Street underwriting firms and issuers with lower credit ratings.
Anticipating that the program could be near death, issuers flooded the market with BABs as 2010 drew to a close.
Mier said the outcome of the election — with Tea Party candidates among the big winners — was the death knell for the program.
“If the result and appraisal of the election had been less extreme, there would probably have been more willingness to fight for the program,” he said.
Its demise was to have a major impact on the municipal market, especially on the long end of the curve, where BAB supply was concentrated.
The stimulus program helped bring record new-issue supply to the primary market. The two years BABs were in existence rank in the top three in terms of annual issuance. The $433.3 billion total from 2010 is the all-time record, while it is likely that 2009’s $409.7 billion would have topped second-ranked 2007’s $429.9 billion had BABs been issued from Jan. 1 on as opposed to April 15.
After averaging just under $23 billion per quarter in the previous six quarters, BAB sales ballooned to $44.2 billion in the fourth quarter of 2010, nearly doubling its average. That helped overall issuance in the fourth quarter skyrocket to $133.8 billion, its highest quarterly total in history. With great supply comes great liquidity.
As soon as the BAB program passed away, municipal bond issuance contracted sharply. Just $12.2 billion was issued in January, according to preliminary data from Thomson Reuters — the lowest volume in any month in 11 years. Consequently, liquidity in the muni market has dried up.
The day BABs were first issued, the 30-year tax-exempt triple-A yield was 4.68%, according to Municipal Market Data. In August, yields began dropping sharply thanks to the effect of BABs as the flood of taxable debt reduced the supply of new tax-exempt bonds. By July 2010 the yield had sunk more than 100 basis points.
As soon as it became apparent the program would expire, yields started to rise dramatically as investors anticipated a sharp increase in tax-exempt supply, given that issuers wouldn’t have BABs to fund projects anymore. In fact, 30-year debt yielded the same on the program’s final day of existence as the day BABs were first issued — bringing things full circle.
Since the program’s sunset ride, yields have climbed as high as 5.08%, a level not seen since BABs were nothing more than an idea. Rates have been pushed higher not only by the expiration of BABs but by a backup in Treasury rates and by headline risk over potential municipal defaults.
Pietronico believes the worst is behind us in terms of the yield adjustment the market has experienced post-BABs.
“The market is now convinced the program is gone,” he said. “The structure and scope of the yield curve reflects that. The market is going to have to stand on its own two feet.”
The program is also survived by $181.5 billion of orphaned taxable BABs left to trade in the secondary market.
The orphans appear to be prospering however, enjoying an inheritance of tighter spreads to comparable Treasuries. The spread over the 30-year Treasury tightened by more than 20 basis points within a month of the death of BABs, according to a Wells Fargo index.
Anthropomorphism aside, in Washington “dead” doesn’t necessarily mean “dead.” Rep. John Mica, R-Fla., the new chairman of the House Transportation Committee, said in December that he plans to introduce a bill in 2011 that would give the bonds a Lazarus-like resurrection.
However, because key Republicans in the House and Senate oppose BABs, most market participants believe the chances of such a rebirth to be remote, at least in the very near future.
Some say the only thing that could bring back BABs now would be a total collapse of the muni market.
“The long-end would have to completely shut down, Pietronico said. “Issuers would have to be completely locked out.”
Assuming the program stays buried, one is left to contemplate its legacy. BABs helped issuers at the height of the financial crisis to keep down borrowing costs, and helped drive down long-term interest rates. The program also widened the investor base of the municipal market beyond those that traditionally are only interested in tax-exempts, like buyers of corporates and taxable government bonds.
“It served the market well while it was here,” Mier said. “It gets high marks in terms of the amount of benefit it provided. It did what it was supposed to do.”
In lieu of flowers, just keep those federal subsidy payments coming.
