The scarcity bid for Build America Bonds is alive and well, demonstrating that investors continue to express interest in a security that has not been issued in more than 16 months and may never be again.
Over most of the past three years, from the time the taxable bond program was launched in summer 2009 to when it expired at the end of 2010 to now, BABs have developed and maintained a level of popularity with investors, according to Citi municipal analyst Mikhail Foux.
He said that remains true today, marked by the fact that the drop-off in liquidity has been slight despite the sparse supply.
“We continue to see relatively active trading in taxables and BABs, though not as active as in 2010,” Foux said.
Yields for BABs, as measured by a Wells Fargo index, have declined precipitously since the sunset of the program, plunging almost 170 basis points to 4.59% at the end of April from 6.28% on Dec. 31, 2010.
And those yields continue to drop. Over the past six months, they have fallen 35 basis points. Part of this reflects the decline in interest rates in general during the period, but investors have noticed that the spreads from BABs to comparable corporate bonds and Treasuries persist in narrowing. And by Citi’s estimates, compared to corporates, BABs are close to fair value in terms of spreads, Foux said.
“So, they’re not cheap anymore,” he said. “There was a substantial repricing of BABs over the last several weeks; some names are 20-to-30 basis points wider. After the correction, while overall we are close to fair value, we have started to see some interesting opportunities.”
Around the end of 2010, one could get an extra 190 basis points of yield from a BAB, on average, over an equivalent corporate bond, said Bedford Lydon a vice president and senior fixed-income analyst at McDonnell Investment Management. That has been cut roughly in half since then.
So far this year, the excess yield of BABs over single-A-rated 10-year corporates has lingered in the 80-to-100 basis points range. For most of 2011, the spread hovered around 120 basis points, Lydon said.
That BABs trade at a large premium to corporates is odd, given that they are typically given higher credit ratings. But comparing an individual CUSIP number for a BAB with that of a corporate with a similar maturity and credit rating shows that spreads narrow considerably, and have actually disappeared in some cases, Lydon said.
The CUSIPs for similar BAB and corporate bonds showed that the spread also tended to narrow if the bonds are higher rated or traded with more regularity, he said.
In addition, the spread of BABs over Treasuries has fallen about 35 basis points since the beginning of the year through April as investors have become more willing to accept more risk for higher yield.
“A good chunk of the decline in yields has been an increased preference for risk since the beginning of the year,” Lydon said. “The BABs hovering with much lower yield spreads to corporates would be explained by the scarcity nature of the BABs, and also probably by investors getting more used to them.”
The Build America Bond program emerged from the American Recovery and Reinvestment Act in February 2009, which empowered municipalities to sell taxable bonds and collect a federal subsidy equal to 35% of the interest cost.
Before the BAB program expired, it generated 2,354 issues and $181.5 billion of debt, according to Thomson Reuters numbers.
In addition, the BAB program and its federal subsidy served as a way for municipalities to lower their borrowing cost for long-term debt substantially by granting easier access to the taxable market. Consequently, a sizeable amount of muni debt issuance shifted to the taxable market from the tax-exempt side.
As the program was set to expire, state and local governments pushed up the supply by selling $133.6 billion of bonds in the fourth quarter of 2010, leading to a record $433.1 billion of issuance for the year.
When the program ended, two schools of thought emerged regarding its effect on the market going forward. One group argued that the BABs would be less liquid because of the lack of new deals.
Others thought there would be some scarcity value to the product and they would appreciate for that reason. BAB yields show that the scarcity camp has proved the winner.
There have been several attempts to bring BABs back, to little avail. Conversations on Capitol Hill revolve around programs that that are similar to BABs, but with smaller government subsidies.
“BABs haven’t fallen out of favor; they’re just hard to find,” said David Abel, a director who does tax-exemption quantitative work at William Blair & Co. and looks at BABs numbers.
Two features color the demand for the bonds. For one, they tend to have longer maturities. That’s because issuers wanted to run the subsidy out as far as they could, Abel said.
Also, the bonds that will see the most activity are those that are considered index-eligible, referring to deals of at least $250 million.
Taxable investors, after all, are those who typically trade corporates — institutional investors who for the most part can’t take advantage of the tax exemption — and so are used to larger trade tickets.
But BABs could become more attractive to retail investors as their maturities gradually shorten, according to Abel.
Finally, he said, investors are growing more accustomed to seeing BABs trade in the secondary market. The fact that there is ongoing taxable issuance as municipal credits helps keep BABs alive.
“If we just never issued anything else taxable, then BABs might become a bit more isolated,” Abel said. “So BABs, in some sense, advanced the market’s reception for ongoing taxable issuance after their sunset.”
In addition, any changes to the tax-exempt market over the next few years could help the taxable market and BABs, Citi’s Foux said. For example, if a sector loses its tax-exemption and thus cannot come to market with a tax-exempt offering, it’s possible that the market will get smaller, he said.
“And by extension, the taxable market will become larger,” Foux added. “So, for investors who keep track of BABs, that’s one of the reasons they continue to be relatively actively involved — they believe that the future will bring an expansion of the taxable market.”
