WASHINGTON — Municipal bond dealers should consider advising customers that issuers of Build America Bonds may have the option to call those bonds starting Jan. 2 if federal interest subsidy payments are cut because Congress fails to address the "fiscal cliff."

In a notice sent by the Securities Industry and Financial Markets Association to its members Friday, the group said customers who purchase BABs and other direct-pay bonds could face investment losses if Congress does not avert "sequestration" that could result in $1.2 trillion in automatic spending cuts to the federal budget.

BABs and other so-called direct pay bonds are subject "extraordinary optional redemption provisions" that allow issuers to call the bonds under certain circumstances, such as when federal subsidy payments are cancelled or reduced.

The federal government pays issuers of BABs, which are taxable bonds, a subsidy payment equal to 35% of their interest costs. Over $102 billion of BABs were issued after they were created in 2009 under the American Recovery and Reinvestment Act and before the program expired at the end of 2010.

Earlier this month, the Office of Management and Budget detailed how sequestration could affect the federal budget and said 7.6%, or $255 million, in federal subsidies for BABs could be cut in the first year. Total cuts for all direct-pay bonds, including Qualified Zone Academy Bonds, Qualified School Construction Bonds and Qualified Energy Conservation Bonds could be $322 million.

"The purpose of the notice is to urge our members to examine the bond documents associated with bonds trading in the secondary market to determine the redemption risks, and to inform their customers ... that there may be redemption risks association with the bonds they buy," said SIFMA co-head of Municipal Securities Michael Decker.

Decker said some bond documents allow for calls if there are changes to tax code or other federal laws that reduce or eliminate federal payments. Others allow calls for "anything at all that causes their subsidy payments to be reduced or eliminated.

Many BABs have "make whole" call provisions, which require issuers to redeem the bonds at a price determined by a formula that reflects market value. Others allow bonds to be called at face value, or at a price above face value, said Decker.

He said many BABs currently trade at premium prices — as much as 115% to 120% above face value. Therefore, an investor could see "the bonds called in January for a price substantially less" than was paid.

Congress has said it plans to address fiscal issues such as the fiscal cliff after the November elections, Decker said, but any delay past Jan. 2 could give issuers a window to redeem their bonds.

With a 7.6% BAB subsidy cut, an issuer would see a reduction from the full 35% subsidy to 32.4%, which would equal 2.6% of total interest costs.

If the federal subsidy is reduced, issuers would need to make up for the costs somewhere else in their budgets.

However, brokerage firm Sterne Agee said in a research brief Friday that most BAB issuers are large entities with solid credit that would be able to absorb an increase in debt service costs. "We do not expect that there will be significant credit pressure or defaults resulting from issuers having to absorb these modest cost increases," said Phil Villaluz, analyst with Sterne Agee. Villaluz said that he does not anticipate large numbers of issuers will call BABs under extraordinary redemption provisions. Such bonds can't be refunded under current tax law.

The economic benefits for an issuer to refinance BABs, even on a tax-exempt basis, would be limited, Villaluz said. If a BAB issuer were to refinance at current tax-exempt bond rates, the savings would be approximately 50 basis points, he said. "Any rate savings would be further reduced by traditional issuance fees along with reputational costs," Villaluz said.

Given the uncertainty of the federal subsidy amounts due to the looming budget cuts, it is "conceivable" that municipal issuers will reconsider their participation in any future government subsidized direct-pay bond programs, Villaluz said.

Separately, Fitch Ratings said Friday that a reduction in subsidy payments could "contribute to a decline in credit quality if bonds were issued with debt service coverage ratios below 1.5 times and pledged revenue, subsequently decline."

Fitch said certain higher education, water and sewer and public power entities have ability to raise rates, which would increase revenues to cover debt service.

"Most states and not-for-profit hospitals did not issue BABs in an amount that would pose any challenges to issuers in the event of a reduction of the subsidy," Fitch said.

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