The biggest success story for the municipal bond market to come out of the American Recovery and Reinvestment Act passed earlier this year is Build America Bonds.
Since the first transaction in April, issuers nationwide have sold more than $47 billion of BABs at net yields significantly below what they could achieve in the traditional tax-exempt market. While the product is not without flaws and should not be thought of as a replacement for tax-exempt issuance authority, BABs have proven themselves as a useful tool for states and localities.
Many municipal market observers, including myself, were skeptical about BABs when they were first raised in Congress last winter. Critics cited a litany of reasons why, due to the municipal market's idiosyncrasies, most municipal issuers could never get good execution in the taxable bond market: small issue sizes, call provisions foreign to many taxable bond investors, different continuing disclosure practices, and the large diversity of municipal credits. And yet, over 500 deals later, BABs have proven to be successful.
BABs come in two versions. With direct-pay BABs, the Treasury Department provides issuers with cash subsidy payments equal to 35% of their interest costs. With tax-credit BABs, investors receive the right to a federal income tax credit equal to 35% of their BAB interest income.
The principal reason why direct-pay BABs are so attractive to issuers is the generous interest subsidy offered by the federal government. BABs often allow state and local issuers to borrow at a rates — net of the 35% interest subsidy — 50 to 60 basis points lower than what they would receive in the tax-exempt market. For many municipal bond issuers choosing between tax-exempt bonds and BABs, the decision is often a financial no-brainer.
BABs offer other, less quantifiable benefits. By opening the municipal bond market to nontraditional investors like pension funds, life insurance companies, and foreign accounts, BABs help assure a stable investor base for state and local debt if traditional tax-exempt investors retreat from the market like they did last winter. These groups of investors like BABs because they are high-quality assets that allow diversification into an area of the credit markets that was not available to them in the past.
BABs have also benefited even those issuers that have not used them. By reducing new-issue supply in the tax-exempt market, they have had the effect of lowering yields there. Estimates of the effect of BABs on tax-exempt yields are in the neighborhood of 20 to 30 basis points or more.
Some who initially criticized the program said that they would favor big issuers over small. Taxable bond investors would never be interested in the debt of small, less-known issuers who sell bonds infrequently and in small issue sizes. While issue size and frequency certainly help attract taxable investors, issuers who have used BABs successfully include California, Albany, Minnesota (which sold an $800,000 deal in May), the Cass County, Neb., School District ($700,000 in August), and the Kankakee County, Ill., School District ($400,000 in September). The average BAB issue size is well under $100 million.
Congress took up the idea of BABs during the height of the financial crisis when the ratio of tax-exempt to Treasury yields was nearing 200% and it was almost impossible for even the most gilt-edged municipal issuers to close deals.
While market conditions have improved substantially since then, states and localities are now dealing with more fundamental outcomes of the recession. Budget gaps are the widest and state and local revenues are the lowest in decades. Standard & Poor's recently said that municipal property tax revenues will continue to feel the negative effects of the real estate downturn and that this will put added downward pressure on credit quality.
Even though the most acute aspects of the crisis have passed, states and localities still need as much help as the federal government can give in accessing the credit markets.
Build America Bonds are by no means perfect. Tax-credit BABs have yet to be issued at all, and it is far from certain whether tax-credit bonds in general can be used efficiently.
Despite assurances by the Treasury Department, some BAB issuers remain nervous about the political viability of continued federal interest subsidy payments and protect themselves by using "make-whole" call provisions that would be triggered if the subsidy is reduced or eliminated, a feature that increases their financing costs.
Secondary market liquidity for BABs is thin, an issue compounded by the risk that if the program is allowed to expire at the end of 2010, outstanding BABs will become an "orphan" product.
Most important, it is vital that federal policymakers not perceive BABs as a replacement for tax-exempt bonds, a tool that has provided trillions of dollars in financing for state and local investment for more than 90 years.
Overall, however, BABs have helped the municipal bond market recover from the worst financial crisis in 75 years and continue to assist issuers in weathering the effects of the recession. As the deadline for BABs approaches next year, Congress and the Obama administration should make the program a permanent component of federal aid for states and localities.