A retroactive 28% cap on the value of tax exemption could trigger the mandatory redemption of billions of dollars of bonds, according to market experts.
A recent research report from Citi estimated that up to $150 billion bonds might be subject to mandatory calls at par if the proposed 28% cap were enacted on a retroactive basis — clearly an unintended consequence that could be used as an argument against such a cap.
The report found that such redemptions, in many cases, would lead to “a substantial loss in market value and income for investors, or a sharp increase in borrowing costs for issuers.”
The retroactive 28% cap has been floated several times — in President Obama’s 2011 jobs bill, his FY 2013 budget proposal and most recently in the fiscal cliff discussions by lawmakers as well as administration officials — as a way to raise revenue. And although the cap didn’t make it’s way into the final fiscal cliff agreement, market experts believe the threat persists as lawmakers and the administration squabble over whether to: raise the debt ceiling; allow sequestration to take place; and adopt another continuing resolution to keep the federal government funded. The current one expires on March 27.
“We believe that there is a significant risk that certain municipal bonds would be subject to mandatory extraordinary redemption, at par, if the cap were to become law,” Vikram Rai, a Citi analyst, wrote in the firm’s Jan. 4 municipal market research report.
Many market experts argue that if a cap is enacted, it should only affect municipal bonds issued prospectively so as not to penalize issuers and bondholders currently holding their tax-exempt debt.
However, making the cap prospectively effective would substantially reduce the amount of revenue to be gained by the federal government, said Tom Vander Molen, a partner in Dorsey & Whitney LLP’s tax and public finance group.
Extraordinary mandatory redemptions have been included in bond indentures for years, well before the recent proposal for a 28% cap, said Scott Lilienthal, president of the National Association of Bond Lawyers and a partner at Hogan Lovells LLP.
They are primarily included in indentures (agreements between issuers and trustees) to protect bondholders and are often associated with private activity bonds. However, some governmental bonds have mandatory redemptions, particularly for cases in which the interest earnings on bonds become taxable. It depends on what the issuer, borrower, underwriter and other bond purchaser agree upon, bond lawyers said.
In the case of bonds that may be tendered for purchase periodically (daily or weekly) by bondholders, the bondholders could decide to demand higher interest rates, in the event that a 28% cap were enacted, Vander Molen said.
Most extraordinary mandatory redemption provisions focus on whether bonds lose their tax-exempt status, said Len Weiser-Varon, a partner with Mintz Levin Cohn Ferris Glovsky and Popeo PC.
He said that while “the odds are against tax calls being triggered on a widespread basis,” concerned holders should look at the specific language in their bonds, which may vary greatly, to see if their bonds could be called if a 28% cap was enacted.
“It is possible that there are some specially negotiated tax call provisions among the billions of dollars of municipal bonds that are triggered by absence of full tax exemption of any of the bonds,” Weiser-Varon said.
In recent days, Weiser-Varon said there has been particular focus that an issuer might take advantage of a tax call and call a bond at par when it is trading above par.
Vander Molen and other tax lawyers emphasized that bond document language varies in terms of whether there is a mandatory redemption or not, and if so, whether the issuer has to pay par or a premium.
“The current economic gain or loss to the bondholder would be the difference between the redemption price and the value of the bond in the market,” Vander Molen said. Sometimes the bondholder will get more then the bond was worth, and sometimes less.”
Whether a bondholder or issuer loses the most in a mandatory redemption also varies.
“It really depends on a number of factors, including whether the interest rate being paid is more or less than what is now the market interest rate for comparable debt,” Vander Molen said.