'Build America Bonds' Forever, or Nevermore?
The Obama administration supports extending them. But if Congress fails to act, we may see a blizzard of BABs this December.
The Obama administration has signaled that it would favor extending the popular Build America Bonds (BABs) feature of last year's stimulus bill. This arrangement allows normally tax-exempt states and municipalities to issue taxable bonds at higher interest rates, but receive a federal subsidy of 35 percent of their interest expenses. The program was intended to provide incentives to states and localities to build infrastructure projects and spur employment. It's due to expire this December.
The administration proposes extending the BAB subsidy program permanently, albeit with a lower federal interest rebate of 28 percent rather than the current 35 percent. Most states and localities would applaud this approach, which provides certainty in the markets, and still offers a compelling incentive to fund programs this way. To provide a long-run perspective that looks beyond today's market anomalies, the recent interest rate on high-grade taxable corporate bonds last week was 5.56 percent according to Barrons' weekly index, compared with a tax-exempt yield of 4.36 percent on 20 high-grade general obligation municipal bonds. Just using those numbers for a frame of reference, a 28 percent subsidy on the average taxable corporate bond would reduce its cost to 4 percent, which would be below the average tax-exempt muni bond rate and save the index-average issuer 36 basis points (0.36 percent) or about 1/3 of a percent annually. On a $100 million bond issue, that works out a savings of $360,000 annually, with a present-value savings of $4 million to $5 million depending how the deal is structured. Saving 4 or 5 percent of a public-purpose bond issue's face value is obviously worth consideration and public support.
Of course, it's not that simple in every case. And there will be some issuers who will find it cheaper to fund projects conventionally with tax-exempt paper. Presently, taxable municipal bonds are trading at higher yields than corporates in some areas. Some municipalities have a strong tax-exempt following of investors and get their deals done on the cheap. So a lot depends on local market conditions.
Is a 28 percent subsidy rate appropriate? With federal income tax rates on the rich scheduled to increase from 35 percent to 39.6 percent, and many state income tax rates in the 5 to 10 percent range, a 28 percent subsidy may look chintzy from the municipal perspective. From the U.S. Treasury's perspective, a 28 percent subsidy to municipalities will certainly be a lot cheaper than a 39.6 percent subsidy to Wall Street bankers and the wealthy. Nonetheless, for many municipalities, the net cost of their borrowing will be reduced this way (as described in the prior paragraph), which produces a win-win for the federalist system. At the end of the day, the answer is that there are more taxable investors, including pension funds and foreign investors, than high-bracket tax-exempt investors, so the BAB program has economic merits.
Legislative effort is needed. Getting this proposal through the Congress will require considerable effort by mayors and governors, so it's not too soon to start lobbying the Hill to secure this important legislation. As demonstrated above, the ongoing program will reduce the net cost of government at all levels. Professionals agree on this: Economists have suggested for over three decades that this "taxable bond option" would be cost-efficient. Some municipal associations nonetheless disapproved of the idea because they felt it would erode the sanctity of the municipal tax exemption. But ever since the Supreme Court's 1988 ruling in South Carolina v. Baker, that argument has lost its punch. (The court held that the states' exemption from federal taxation was not a constitutional right or privilege.) The bigger problem someday could be that if the federal government runs out of revenue because of spiraling Social Security and Medicare costs and the interest on its own debt, there may not be funds remaining to make good on these promises to keep sending subsidy checks to municipal bond issuers. That is probably the greater financial risk in the long run.
A December blizzard of BABs. If the BABs are not renewed, you can expect a spike in issuance volume this December, as underwriters and financial advisors spur procrastinating issues to get their deals done while the subsidy is still available. And even if the program is extended, the reduction of the subsidy rate from 35 percent to 28 percent will create a cliff effect of similar proportions. That would push interest rates on BABs higher temporarily in December, to be followed by more normal market conditions in January 2011. Either way, state and local government managers and elected officials should start getting their ducks lined up now to sell their bonds earlier in this year. Add to that the potential for an eventual economic recovery that could force the Federal Reserve and bond vigilantes to raise interest rates, and you have every reason in the world to sell BABs sooner rather than later. From the standpoint of the federal stimulus program, that would be a good thing, as it would put more construction money into the struggling American economy sooner rather than later -- and help reduce the risk of a double-dip recession.
A pension fund buying opportunity? My prediction of a glut of BABs this December suggests an unprecedented and perhaps unique opportunity for pension funds and their bond portfolio managers to load up on BABs at high yields at year-end, and then trade them out for a profit in 2011 when issuance volume subsides. Every public pension fund administrator and trustee in America should be asking about this opportunity, and if your investment policy somehow does not presently allow BABs, it might be wise to include them, in case the volume of issuance is high enough to make this strategy worthwhile.
My January column on this topic addressed some other nuances that curious or serious readers of this topic may wish to revisit. You can view it by clicking here.