John E. Petersen was GOVERNING's Public Finance columnist. He was a Professor of Public Policy and Finance at the George Mason School of Public Policy.E-mail: email@example.com
April 15, the day federal taxes are due, is not usually a cause for celebration. But this year it marked the first anniversary of Build America Bonds, dubbed BABs, a new type of bond for the municipal market. Grabbing onto this bundle of joy, the market put its party face on and has been singing Happy Birthday with gusto.
State and local issuers are among those with the loudest, happiest voices. The Texas Department of Transportation, for instance, will be using proceeds from the new bonds to make highway improvements; Chicago, sewer upgrades; and Kansas, improvements to its public schools.
All totaled, it was a very impressive first year for the new baby. Government agencies in 48 states issued BABs. Some $90 billion came to market--about 22 percent of all the dollar volume of borrowing done by states and localities in that time period.
There were, of course, a few bumps and bruises along the way. But overall the BABs program has changed the market for state and local government obligations for the better. The major question now--will it last?
Build America Bonds are different from traditional, tax-exempt municipal bonds: The interest income on BABs is fully taxable by the federal income tax. This would normally be unattractive to issuers--if the interest rate is taxable to investors, issuers must pay those investors a higher rate. But with BABs, the federal government pays the state or local issuer a subsidy equal to 35 percent of the interest rate. Government issuers must run the numbers to see if, at the time and under the circumstances they are coming to market, BABs are less expensive than selling a traditional muni bond. When Washington state issued its first BABs in October2009, it found that the $500 million offering for transportation projects had significant interest-rate savings over a tax-exempt version. "Without the Build America Bonds program," said State Treasurer James McIntire at the time, "these bonds would have cost taxpayers another $62.4 million over the life of the bonds--enough to buy another passenger ferry."
Bottom line: Municipal issuers now can access an affordable way to issue a bond with taxable interest. That's an important breakthrough. The municipal bond market has long been sequestered in the sense that traditional tax-exempt bonds were only of interest to American investors that pay U.S. income taxes. This excluded many domestic institutional investors (such as nonprofits and governments), as well as foreign investors. So BABs adds new names to the issuer's Rolodex--a whole new pack of investors are potential buyers. That's how the Texas Department of Transportation saw it. In discussing the bonds on its website, the department noted that BABs provided it with "another option to access a broader investor base, as well as reduce borrowing costs."
During the first year of BABs sales, the initial buyers were institutional investors--bond funds, money manager funds (such as mutual funds) and life insurance companies. As the program became better known, a second wave of buyers, including pension systems, began buying BABs. The third wave, sales to individual investors, is now beginning to grow.
As to foreign investors, many are interested in investing in high-quality infrastructure projects. But foreign investors have tended to see the municipal bond market, which finances such projects, as an American curiosity since they saw no advantages in holding its tax-exempt securities. Now with the availability of a taxable bond, those foreign investors are trying to wrap their arms around the United States' political structure, where each of the states is sovereign and there are no federal guarantees of the debt. Even more challenging is the idea that thousands of local governments troop to the financial markets each year and sell bonds on their own credit, a situation for which there's no comparison throughout the globe.
Foreign investors seem to be coming around, especially as BABs enter their second year. But there have been other problems. There were early complaints that the underwriting costs (the margin that the investment banks charge for doing the deals) were too high. There is no question that the initial deals were expensive, with costs around $8 per $1,000 in bond amount. By early this year, the underwriting spreads had declined to about $6.50 per $1,000, still slightly above the $6.20 per $1,000 average in the tax-exempt market.
The high underwriting fees were a function of the new market getting started, plus an opportunity, no doubt, for underwriters to make some money on the new bonds' novelty. But as BABs issues came marching forward in greater number, competitive pressures have pushed the underwriting fees down.
Of more concern is the federal subsidy, a source of continuing debate. It's hard to argue that it hasn't helped expand the municipal bond market and lower issuers' borrowing costs. Many bond issues are competitively auctioned off by taking bids for the bonds on both a taxable and tax-exempt basis. The bonds are awarded to whichever deal will be cheapest. So far at least, BABs have been saving interest costs for the issuers.
But the reasoning is really more complex. The borrowing costs for all state and local governments have fallen in relationship to those on other borrowers' instruments. That's so because of the reduced supply of tax-exempt securities, thanks in part to the BABs option. In other words, the benefits of interest-cost savings extend not only to those issuers that use the BABs program, but also to those that do not. The program, however, comes at a long-term cost to the federal government, which will pay a 35 percent subsidy on every dollar of interest paid over the life of a Build America Bond.
Comparing the benefits to state and local governments to the program's costs is a difficult but politically important exercise. The U.S. Treasury Department has signed onto $23 billion in future interest subsidy payments resulting from the $90 billion in BABs sold in the first year. In present value terms, this amounts to $19 billion in costs. Treasury officials estimate that Build America Bond participants have toted up reduced-interest costs of $12 billion on the $90 billion of BABs sold so far. By this reckoning, the federal government is paying a $1.90 subsidy for every $1.20 that states and localities are saving in interest costs.
But that calculation is only part of the story. With a smaller number of tax-exempt bonds available, the law of supply and demand went into effect, resulting in lower interest rates on the $380 billion in traditional municipal bonds sold in 2009. How to calculate these added savings in interest cost is debatable. But one estimate, based on differences in yield curves between taxable and tax-exempt bonds, is another $8 billion to $10 billion in the present savings' value on tax-exempts.
Economists will face a chore in sorting out all these market effects and their implications for interest cost savings. But it's likely that the total reduction in borrowing costs for state and local governments, after combining savings on both the BABs issues and the tax-exempt issues, will match or perhaps even exceed the cost of the interest subsidy to the federal government. In sum, that means the taxable-bond subsidy, working through the financial markets, pretty much pays for itself by making tax-exempt borrowing more efficient. That is, investors' tax savings were largely passed along to the borrowing governments in the form of lower interest rates. Whatever the precise dollars and cents, the outcome has been a huge reduction in borrowing costs over what likely would have been the situation.
The Obama administration proposed to continue the BABs program beyond 2010, but at a lower subsidy rate of 28 percent. Alternative bills call for setting the subsidy rate at 30 percent and expanding the allowable uses of the BABs program to include not-for-profits, such as hospitals. The 35 percent subsidy was evidently an "introductory offer" to kick-start borrowing for infrastructure spending--and to grease the skids for acceptance of the taxable-bond idea.
It seems clear that the BABs program has developed a constituency--here and abroad. After years of seclusion in the tax-exempt market, the premier state and local credits are mixing it up with the big corporate and foreign country credits. This is one area where "Buy America" campaigns may have considerable success.
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