Getting Ready for Build America Bonds
There's a new tool for financial officials and managers to master.
Public officials are just now learning about a potentially important financing tool that Congress created in the new American Recovery and Reinvestment Tax Act, as the stimulus package is formally known. "Build America Bonds" is a new name for a seasoned, yet innovative, idea that I discussed earlier this year in a column on the taxable bond option.
Under ARRTA, municipalities can receive a 35 percent federal reimbursement of their interest costs -- if they elect to sell taxable bonds in lieu of their traditional tax-exempt securities. Alternatively, the bond investors could receive a 35 percent tax credit, but that option has less value in a sour economy where investors are claiming tax losses, not gains. A higher federal subsidy is allowed for Economic Recovery Zone bonds, but those are limited in volume and for narrower purposes.
Build America Bonds are a big deal in governmental finance today. They offer municipalities a potentially lower cost of funds for capital projects. Plus, they could be attractive investments for certain public pension funds and OPEB (retiree medical benefits) trust funds. Pension administrators, trustees, CIOs, investment advisers and financial officers now need to learn about a new asset class. Taxable municipal bonds will pay higher interest rates than U.S. government and agency bonds, and many of them will be safer than corporate bonds with similar yields and ratings.
This column highlights the key features for public managers to understand and master.
1. Limited issuance window. Build America Bond reimbursements apply only to qualified issues sold before the end of calendar year 2010. The issuers will continue to receive their tax-credit payments (reimbursements from Uncle Sam) for the life of the bonds sold during this period. Congress intended for these tax benefits to spur construction projects, so a wait-and-see approach may not be the best strategy here. That said, I hold out hope for federal guarantees of muni bonds as advocated in my previous column, and those who rush to market now might miss that benefit if the recession worsens and Congress then offers a "better deal." Natural procrastinators and ambivalent officials who prefer to sit on a fence a while might wait until 2010 to see if Congress acts or if municipal risk premiums (higher rates than Treasury bonds) recede. Please don't blame me, however, if nothing favorable develops.
2. Other rules for tax-exempt securities apply. Even though these bonds will be sold in the open markets as taxable bonds, they are still subject to a host of rules that constrain and qualify the issuance of tax-exempt securities. Also, if the deal was not eligible for a tax exemption in the first place, it is not eligible for the federal reimbursement either.
3. Qualified purposes. Municipalities may sell Build America Bonds only for qualifying governmental purposes. Generally that means general-obligation bonds for capital expenditures, although certain revenue bond deals may also qualify if sold strictly for governmental purposes. Cash-flow borrowing, pension obligation bonds, OPEB bonds, private activity bonds and conduit financings generally are not eligible for the federal reimbursement.
4. Start with a financial adviser. You first need to determine whether a taxable bond can be issued at a lower cost than you would pay in today's market as a tax-exempt issuer, after considering the federal reimbursements. The 35 percent federal reimbursement is intended to provide fair compensation for the tax advantages your bond purchasers will forgo when they buy your bonds, but some municipalities may find little appetite for their paper in the taxable market. Thus, you need to determine in advance whether this is really the right strategy for your projects. You should also determine whether your bonds could qualify for the richer tax credits under the Economic Recovery Zone provisions.
Your financial adviser may also inform you that major buyers in the taxable market most likely would prefer to see single "bullet" maturities rather than the traditional serial maturities commonplace in the tax-exempt marketplace. That aspect alone may reduce the appeal of this option, especially in light of higher interest rates on longer maturities, which can dilute the savings for most issuers.
5. Check with bond counsel. To make sure that your intended financing is eligible, you will want to ask your bond attorney to verify your understanding. Even with a competent and experienced financial adviser, you will want an independent predetermination by bond counsel that you are heading in the right direction.
6. Discuss with elected officials and other policymakers. This is not just a financial decision for numbers geeks to make. There is a significant policy question that finance officers will ignore at their peril. Not everybody thinks that this deal is a good idea. The Government Finance Officers Association has opposed the taxable bond option proposals, on principle, for 20 years. GFOA's rationale goes to the historical Jeffersonian-federalist heart of the municipal tax exemption and more pragmatically to the long-term demand for tax-exempt securities. GFOA fears both will be eroded if the TBO gets too popular.
One of GFOA's pragmatic concerns should be discussed with policy-makers before approving a Build America Bond deal: There is a least a theoretical risk that a future Congress could run out of money because of other entitlement commitments such as Social Security and Medicare. In that crisis scenario, the U.S. might renege on its promise to pay municipalities their Build America Bonds reimbursements. (That's why my policy proposal in the prior column on the TBO favored an up-front payment of the present value, to eliminate this risk.) Most financial analysts would downplay this concern as a doomsday scenario in light of the federal government's power to print money. But in these stressed-out days of depression-chatter and extreme anxiety about the future of the federal budgets, this topic is probably a mandatory feature of due diligence for a professional finance officer to address.
7. An investment opportunity. These Build America Bonds are a legitimate new asset class that warrants consideration in building new pension and OPEB trust portfolios from the ashes of this market meltdown. Public finance officers should make sure that these bonds become eligible for purchase by public pension funds and OPEB trusts. In some cases, this can be done through investment policy changes; in some cases no further action is necessary because the authority is already there; and in other cases a legislative amendment may be necessary. There is a natural appetite for high-quality taxable municipal paper in a public pension or OPEB trust fund. They may be the best investors for such bonds because retirement fund portfolios don't need as much liquidity or marketability as other investors, and these bonds will trade weakly in those features. But, when municipalities eventually recover from their now-distressed revenue problems, the higher coupons on these Build America Bonds could look pretty smart inside a long-term benefits plan's portfolio.
A few caveats are in order, however. I'm not a big fan of municipal issuers pushing their own paper off to their own pension plans, especially in the wake of the disastrous experience of companies loading their stock into employee 401(k) plans. I'm even more leery of the scheme concocted by one disingenuous adviser who tried to persuade school officials to buy each other's paper in a daisy-chain of OPEB financing to exploit a loophole in school tax rules. These schemes flunk the diversification and prudence tests. One idea might be for issuers to work with a private adviser to professionally assemble diversified portfolios of these securities to provide prudent investments for retirement trust funds.
Potential savings, like a supermarket's discount club? Although municipalities will pay a higher interest rate on taxable bonds they elect to issue, the federal reimbursement should reduce their net borrowing costs to less than a conventional tax-exempt deal. That said, this arrangement reminds me of the grocery-store receipts that I get every time I buy slightly overpriced supermarket "club" products at a "member mark-down" price. The cashiers remind me that I saved $30 or $40 on their private-label products, but in my heart I know that my actual savings were less. Sure, I saved some money, but it wasn't as much as they try to tell me. So it will be in public finance as well. My best guess is that the average issuer could save 50 basis points net-net.