There is no shortage of detractors when it comes to President Obama’s economic stimulus package. One portion of the plan, however, has met with unanimous approval: The Build America Bond program.
Why? Because these municipal bonds, known as BABs, have done precisely what was intended and more. They have provided a vehicle for local governments, cities and states to tap new capital markets and lower their financing costs.
Although these taxable securities carry a higher interest rate than tax-exempt bonds, the federal government reimburses 35% of the interest expense to the issuer, thereby lowering the net interest cost to the municipality.
The popularity of these issues has far exceeded all expectations. BAB issues have totaled close to $60 billion since their inception in April.
Tax-free bonds benefit from BABs
As muni investors know, the onset of the credit crisis had a devastating effect on tax-free bond market prices (see What’s Up with My Market Values).
At the height of the crisis, major financial institutions, tax-free bond funds and leveraged hedge funds were forced to liquidate large portions of their municipal bond holdings. These institutions, which had formerly provided support to the market, became massive sellers of tax-frees. The overwhelming supply of bonds in the marketplace far outstripped the demand for these securities from individual investors.
During this period, municipalities were also forced to postpone issuing new debt to fund projects. BABs provided a much needed solution by issuing higher yielding taxable securities, which expanded investor demand to include life insurance companies, major pension funds and foreign accounts.
The Build America Bond program is scheduled to expire at the end of 2010, but investors and portfolio managers are lobbying to extend it. House Ways and Means Committee staffers have indicated that Congress is likely to continue the program well past the initial deadline.
Michael Mundaca, President Obama’s nominee to become the Treasury Department’s assistant secretary of tax policy, told the Senate Finance Committee that “the BAB Program is too successful to simply allow it to expire.”
Why is this significant to the traditional tax-exempt bond buyer?
BABs have been a win-win-win situation for the municipal bond market.
They allow taxable investors to diversify into high quality assets in a sector of the credit markets that was not previously available to them.
Municipalities are winners because they can borrow at a lower net interest cost at a time when revenues are declining.
The third but less obvious winner will be the traditional tax-free bond investor’s portfolio.
With increased demand, muni yields favorable now
According to J.P. Morgan, new issuance of BABs is projected to rise more than 40% to $110 billion in 2010. This will have a dramatic dampening effect on the outstanding supply of tax-exempt securities.
At the same time, it is impossible to find a politician or economist who doesn’t believe tax rates have to rise to accommodate the record deficits being produced in Washington.
Many formerly marginal investors will be pushed into higher tax brackets, creating considerably more demand for tax-exempt securities.
Clearly, with BABs reducing the supply of tax-free munis while higher tax brackets heighten demand, it is not difficult to predict that investors buying high quality tax-free bonds yielding 5.00% or more today will be very pleased they did.
