CHICAGO — For Illinois, Build America Bonds are the gift that keeps on giving despite heightened federal scrutiny, the state’s debt manager said last week.
But the federal government will pay a political price if it pursues measures that dampens the program’s popularity among issuers, said John Sinsheimer, Illinois’ director of capital markets.
“If they make this program unattractive after all the benefits it’s created — and with job creation as its goal — there’s going to be some serious political kickback,” Sinsheimer warned during a panel discussion of the BAB program at a public finance conference sponsored by Information Management Network here last week.
Sinsheimer’s comments came after the Internal Revenue Service said it would audit up to half of all BAB transactions, though late last week it backed away from that figure.
At the same time, there is a growing number of issuers whose BAB payments — currently set at a rate of 35% of interest costs — are being offset or reduced by amounts of money they owe the federal government in non-bond-related programs.
With a total of $3.9 billion of outstanding BABs, Illinois is one of the largest issuers of debt under the program, created as part of the federal stimulus law. The state has two more issues totaling $1.2 billion on tap to sell this month.
Issuing BABs saves the state roughly $65 million in interest costs per $1 billion issued, according to Sinsheimer. The program has broadened the state’s investor base to include taxable buyers and international investors new to Illinois paper. State officials also estimate that it has created 20,000 jobs for every $1 billion of BABs issued.
Those benefits continue to outweigh the drawbacks, Sinsheimer said. But the state is preparing for rising federal oversight by putting its finance teams on notice that they need to ensure that all trading and documentation is in compliance with the IRS.
The state is now requiring its underwriters to sell all BABs at par and to provide certificates proving that the securities were offered at the initial offering price. It is also requiring bond counsel to make sure all documentation is complete and compliant with the IRS.
“We’re asking underwriters to produce EMMA trade sheets for us, and we’re asking our [financial advisers] to be on the watch,” Sinsheimer said, referring to the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access system. “We’re also putting counsel on notice that as a matter of policy, the state is looking to them to ensure that documentation is clear and complete and would satisfy the IRS.”
Of the state’s five BAB transactions, officials are expecting at least two to be audited, he said.
“Don’t be afraid, be prepared,” Sinsheimer added.
The IRS’ audit threat is consistent with the agency’s historical approach to the tax-exempt market, said Brian King, managing director at Cabrera Capital Markets LLC, who spoke on a panel with Sinsheimer at the conference.
“The IRS’ position is that tax-exempt debt is a privilege not a right, and that privilege can be revoked,” King said. “What they’re doing here with the audit threats is consistent with the way they’ve always been. They’re putting a shot across the bow to issuers and bankers that they want to make sure the bonds are priced fairly. As issuers, it’s critical that you press your bankers and FAs and make sure you’re getting the best information available in the market.”
The threat of payment offsets is not much of a concern to the state, mostly because Illinois does not pledge the federal subsidy as collateral to bondholders, Sinsheimer said.
“The state’s position is, first of all, we have millions of dollars a week moving between Washington and Springfield,” he said. “We always owe them and they always owe us, and like all good relatives we are in constant dispute. But the dispute is between us and the IRS, and what we may owe is not a problem for the bondholders.”
Meanwhile, Cabrera’s King said many BAB issues are increasingly being structured like traditional tax-exempt debt.
In the beginning, most issuers structured the bonds to appeal to taxable buyers unfamiliar with municipal credit and debt structures. That meant pushing BAB maturities to the long end of the yield curve, featuring bullet instead of serial maturities, and removing the traditional tax-exempt 10-year call feature.
“The lion’s share of the $1.4 billion issued in 2009 and early 2010 incorporated that structure,” King said.
For issuers, the problem was that they could not take advantage of interest rates at the short end of the yield curve.
Since then, he said, taxable buyers have become more comfortable with tax-exempt debt structures as well as the underlying credit characteristics of the issuers.
“Now that taxable buyers have had an opportunity to work with municipal debt, they’re more comfortable with serial structures and they understand municipal credits and ratings,” King said. “So serial bond issues can take advantage of the short-end of the yield curve.”
But many BAB investors are still reluctant to purchase debt with a 10-year call, he said.
“We haven’t seen as much evolution with that as we would hope for,” King said. “One area that we’ve seen a little bit of give amongst taxable buyers is smaller issues. We see a little bit more willingness to charge a smaller fee to take a 10-year par call, but on the larger deals are still seeing corporate type structures on the call.”