WASHINGTON -- The federal subsidy payments made to issuers of Build America Bonds and other direct-pay bonds will be cut by 6. 6% in fiscal 2018 under sequestration, the Internal Revenue Service announced.

The 6.6% cut will apply to subsidy payments processed on or after Oct. 1 of this year.

The reduction is slightly smaller than 6.9% cut in the current fiscal year that ends Sept. 30.

The sequestration cuts are automatic, annual, across-the-board cuts for defense and nondefense discretionary programs which stem from Congress' failure to reach an agreement over how to significantly cut the deficit.

In addition to cutting federal subsidy payments for BABs, the sequestration cut also applies to qualified school construction bonds, qualified zone academy bonds, new clean renewable energy bonds, and qualified energy conservation bonds.

The sequestration cut is not cumulative and resets to a new percentage each year.

Fiscal 2018 will be the third consecutive year the cuts have remained under 7%. The cuts were 7.3% in fiscal 2015, 7.2% in fiscal 2014 and 8.7% in 2013.

Emily Swenson Brock, director of the Government Finance Officers Association federal liaison center.
Emily Swenson Brock, director of the Government Finance Officers Association federal liaison center. Brian Tumulty, The Bond Buyer

Emily Swenson Brock, director of the Government Finance Officers Association federal liaison center, said at least the rate is lower.

“While State and local governments that have issued BABs would be most satisfied to see the refund rates rectified to the original 35% level, it’s good to see the downward trend of the sequestration rates since 2013,’’ Brock said in an email. “As this downward trend continues, it may be likely that states and local governments will revisit debt structures and evaluate strategies that would mitigate future risk brought on by sequestration.

She said the 35% federal subsidy rate will be reduced to 32.69% with sequestration of 6.6% in fiscal 2018.

For each of these types of bonds, issuers had the choice at one time or another to issue them in direct-pay mode rather than as tax-credit bonds. In direct-pay mode, the issuer gets subsidy payments from the Treasury Department or Internal Revenue Service that are typically based on a percentage of their interest costs.

The America Recovery and Reinvestment Act created BABs, allowing state and local governments that issued them in 2009 and 2010 to receive subsidy payments equal to 35% of their interest costs. The payments are to be made throughout the life of the bonds.

Some BAB issuers have either redeemed or announced they can redeem their bonds because sequestration triggered extraordinary redemption provisions in their bond documents.

The sequestration cuts have soured many issuers on direct-pay bonds, even though some lawmakers and the president have proposed extending the BABs program at a lower subsidy rate.

Michael Decker, managing director of the Securities Industry and Financial Markets Association and co-head of municipal securities, said his organization was “not surprised by the IRS announcement.’’

“Build America Bonds subsidy payments have been reduced, since the sequester was enacted,’’ Decker said. “It is unfortunate, that municipal issuers committed to use this product based on an initial promise of payments from the federal government equal to 35 percent of interest costs, and now those governments are being short-changed."

Sequestration of mandatory spending was initially supposed to last through fiscal 2021, but it was extended through fiscal 2023 under a 2013 budget agreement. It was then extended through 2024 in February 2014 in a bill that repealed reductions in cost of living increases for younger military retirees.

A budget deal in October 2015 extended sequestration to fiscal 2025.

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