Unexpectedly, municipal bond prices have been the first major beneficiary of the federal government’s new stimulus package, with the rollout of its “Build America Bonds” (BAB) program.

Enacted last month, the program enables traditional tax-exempt borrowers to issue taxable debt for municipal purposes.

Win-Win Situation

Under the new BAB arrangement, the federal government provides municipal issuers a 35% rebate on the interest cost incurred on their bonds. This means that even though the municipalities are borrowing at a higher rate, the government subsidy makes it less expensive than borrowing in the tax-free market. Additionally, the government funds enhance the security of the bonds for investors.

Since the initial $3.5 million bond issue from the small city of Steven’s Point, Wisconsin, there has been a steady parade of municipal issuers tapping this market for funding.

The largest issue has come from the state of California, which sold $5.2 billion of BABs.  Hard on its heels was the New Jersey Turnpike with $1.375 billion, and the New York Metropolitan Transit Authority with $750 million.

Taxable bond funds, pension funds, insurance companies and other institutional investors have displayed a voracious appetite for these newly issued securities. They have also experienced extraordinary demand from individual investors for IRAs and other retirement accounts. All of the issues previously mentioned are trading at significant premiums to their original issuance prices. One noteworthy reason for the BAB’s appeal is that munis have always had a much lower default rate than corporate debt.

Supply and Demand Market

The BAB program is designed to relieve much of the stress on municipal issuers, who in the past relied heavily on private bond insurers to assist them in gaining access to lower rate financing.

Along with the overall interest rate environment, municipal bond prices are heavily influenced by supply and demand considerations.

The success of the BABs has caused a surge in the prices of tax-free bonds, since the obvious impact of these BAB financings will be to limit the supply of traditional muni bond issuance.

Muni yields decline

The Bond Buyer Revenue Bond Index, which measures 30-year revenue bond yields, declined to 5.49% on April 24, which is the lowest level for this index since September 18, 2007.

The rapid decline in muni yields in the last 25 trading days has caused the spread between 30-year and one year bonds to narrow by 40 basis points, according to Municipal Market Data.

As we said in our recent commentary, Why Waiting Doesn’t Work, “There are many factors today which would suggest that muni rates will likely stabilize or decline.” The potential reduction in supply brought about by the issuance of BABs can be added to the list.

James A. Klotz is the President of FMSbonds, Inc. Email the Author04/27/2009