WASHINGTON — Market participants are questioning why Sen. Ron Wyden is drafting legislation that would create a new type of tax-credit bond for transportation projects, warning there is not much of a market for tax-credit bonds.
The Oregon Democrat is expected as early as this week to introduce legislation that would create tax-credit Transportation and Regional Infrastructure Project, or TRIP, bonds. The legislation would allow up to $50 billion of the bonds to be issued through an independent transportation finance corporation over six years. Every state would be entitled to at least 1% of the funds, sources said, speaking anonymously because the legislation is still being drafted. Wyden is still looking for a Republican co-sponsor before the measure is introduced, they said.
Earlier this year, Wyden said he was interested in reviving the popular Build America Bond program, though at a lower subsidy rate. BABs, which were created by the American Recovery and Reinvestment Act in early 2009, were taxable but issuers received payments from the federal government equal to 35% of their interest costs.
The BAB program expired on Dec. 31 but market participants have been clamoring for its reinstatement. BABs broadened the investors interested in munis, attracting public pension funds and endowments, which are already tax-exempt and therefore do not invest in tax-free debt.
But Republicans balked at the direct-pay model for BABs, saying it was too lucrative for underwriters and encouraged issuers with lower credits to borrow more so they could get higher subsidy payments. Multiple efforts to revive the BABs program at lower subsidy rates have been thwarted by Republicans.
Now, Wyden’s down-shift to tax-credit bonds may fizzle on arrival. The model for tax-credit bonds may be more palatable to Republicans, but market participants are skeptical Wyden’s proposal can jump start a market for them.
“The limitations we’ve seen with marketing tax-credits to investors suggests [Wyden’s] product is relatively inefficient in terms of providing low-cost financing to borrowers,” said Michael Decker, a managing director and co-head of the muni securities group at the Securities Industry and Financial Markets Association.
Decker applauded Wyden’s effort to find a capital markets option for transportation financing as a supplement to federal grants, but warned, “There isn’t a real broad or deep market for tax-credits.”
Tax-credit bond investors can take tax credits on their federal income taxes at a rate that is set by the Treasury Department. Traditional bonds offer cash interest payments to investors.
Tax-credit bonds have existed since 1998, but have never caught on with investors, despite federal lawmakers continuously authorizing more money for them. Congress first created qualified zone academy bonds, which allow certain schools to finance school rehabilitation projects. After authorizing $400 million of QZABs per year for 10 years, Congress authorized an additional $1.4 billion for them in 2009 and 2010. Yet only 71 issues totaling $251.9 million of QZABs were issued in those two years, according to data from Thomson Reuters.
The stimulus law also created up to $22 billion of tax-credit qualified school construction bonds, which can be used to finance school construction. Initially, these bonds could only be sold as tax-credit bonds. But once the BABs direct-pay model proved to be successful, federal legislation enacted in March 2010 allowed the QSCBs to have a direct-pay option as well, allowing market participants to treat them like BABs.
About $3 billion of QSCBs in 208 issues were sold during the first 11 months when they could only be issued as tax-credit bonds, according to Thomson Reuters. In the 11 months after the direct-pay option was added, 512 issues totaling $7.3 billion were sold.
“The direct-pay model works fabulously. It is the better model,” compared to tax-credit bonds, said Joseph McLiney, a banker with McLiney and Co. in Kansas City that specializes in tax-credit bonds. He said he has been consulted by municipal finance advisory firms that are already asking if a market can be made for tax-credit bonds Wyden wants to create.
The investor community for tax-credit bonds is small, limited to long-term bond buyers who pay income taxes like life insurance companies and banks. Scott Minerd, chief investment officer at Guggenheim Partners LLC, estimated the market for TRIP bonds would be less than $2 billion annually under the current tax-credit rules.
“I’m a little surprised that [federal lawmakers] are attempting this again given that the QSCB tax credits were widely viewed as a failed social experiment,” Minerd said. Guggenheim bought more than 50% of QSCBs before they could be issued as direct-pay bonds..
To attract interest in this small tax-credit investor community, issuers often had to sweeten the deal by offering a supplemental coupon. QSCBs were issued below par value and offered investors about a 1% to 2% interest return at maturity, Minerd said.
Market participants said the lackluster demand for tax-credit bonds, combined with legislative changes that initiated the direct-pay option for QSCBs, will make it exponentially harder to create a market for TRIP bonds. QSCB issuers swarmed to the direct-pay option after Congress authorized it, effectively squeezing off the market for tax-credit bonds. Now with Wyden’s bonds, tax-credit investors will be wary of federal interference in the market and will likely demand a higher return from issuers.
However, three factors are working in favor of the forthcoming Wyden proposal. First, the cost of TRIP bonds to transportation issuers could be significantly less than the financing tools they now have available. Even with a supplemental interest cost needed to attract investors, transportation project managers may find the tax-credits are worthwhile because other financing methods are even more expensive, according to Guggenheim.
Second, if the bonds are backed by a moral obligation of the federal government, similar to the federal support provided to the debt of Fannie Mae and Freddie Mac, it would generate “substantially greater demand” for the TRIP bonds, Minerd said.
Wyden’s draft proposal calls for TRIP bonds to be issued by an independent transportation financing corporation. This authority would be made up of representatives from state infrastructure banks. It remains unclear if this authority would provide federal credit support.
Sources agreed that a federal backstop for the TRIP bonds would solve the credit-quality problem that came up with QSCBs, which are issued for school districts. The TRIP bonds would be homogenized if they came from one issuer, which could potentially generate more liquidity for the bonds.
Third, demand for TRIP bonds also could be boosted if the tax credit could be stripped from the underlying debt. The Internal Revenue Service has issued guidance governing stripping for existing tax-credit bonds. A source familiar with Wyden’s proposal said the TRIP bonds would also be strippable. However, the Internal Revenue Service has not yet been consulted on the stripping options for the TRIP bonds, the source said.
But the concept of stripping the tax credits from taxable debt is complicated and treads into uncharted territory. The questions that reoccur are, how does one strip a tax credit from a callable bond and what happens to the tax credit if the bond defaults?
“If you could strip the bonds, then you would dramatically increase demand for the securities,” Minerd said. Demand from hedge funds and other specialty investors would decrease the interest cost to the issuer, he said.
One option to fix tax-credit bonds would be to make the tax credit refundable, a banker said. If the tax credit could be traded into Treasury for cash, after a certain period it would make the tax credit behave more like cash and would attract more investors, he said.
Ultimately, market participants said they should be consulted about TRIP bonds if they are to be successful.
If members of Congress “are going to ram this down our throats then they better ask someone who knows how to do it to put it together,” McLiney said. The TRIP bonds “could be designed correctly, but nobody cares to ask,” he said.