Build America bond

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See also municipal securities, muni swaps and Municipal Securities Rulemaking Board.



Congress and President Barack Obama included the Build America bonds in the American Recovery and Reinvestment Act in an attempt to enable cities and states to access the debt market again, after the municipal bond market virtually froze in 2008.

Issuance of the bonds is limited to infrastructure improvements.

BABs likey to expire under tax plan

Monday night’s compromise on extending the Bush tax cuts and unemployment insurance also kept alive policies that were introduced in the 2009 stimulus package — but one was conspicuously left out.

From Bloomberg Businessweek:

An extension of the U.S. Build America Bond program was left out of a compromise that President Barack Obama struck with congressional leaders to prolong tax cuts enacted in 2001 and 2003, White House officials said. …

The fate of the Build America program, which Obama has sought to extend, may be determined by a six-member panel headed by Treasury Secretary Timothy Geithner, the White House officials said. Panel members were appointed by Obama and congressional leaders to negotiate tax issues.

The proposal under consideration would have extended the programme, with a decrease in the federal subsidy on the interest payments on these taxable bonds from 35 per cent to 32 per cent.

According to the Bond Buyer, the bill was opposed “because the Senate’s lead Republican negotiator, Jon Kyl, R-Ariz., has been a harsh critic of the program, which is set to expire on Dec. 31.” His primary complaint was that the subsidy led states and localities to borrow more than was implied by their credit ratings. Of course, the point of Build America Bonds was to make it easier for conventional issuers of muni debt to compete with yields offered by corporates.

1 year BAB extension proposed

Senate Finance Committee chairman Max Baucus on Thursday proposed to extend the Build America Bonds program for only one year in legislation he unveiled that would extend several expiring or expired bond and tax provisions.

The Montana Democrat introduced the Job Creation and Tax Cuts Act, which includes a provision that would extend BABs through 2011 at a 32% subsidy rate. That’s half as long as comparable legislation introduced in the House, which would have extended the program for two years and provided a 32% subsidy rate for BABs issued in 2011 and 30% rate for those sold in 2012.

Even though extenders legislation is now pending in both chambers of Congress, market participants contend the legislation will not gain significant traction until after the elections, during a lame-duck session.

The BAB provision was likely halved to cut the cost of the measure, sources said. Baucus touted his bill as fully paid for with revenue-raising offsets. The one-year BAB extension was estimated to cost $2.76 billion over 10 years, whereas the two-year extension proposed in the House would have cost $4.042 billion over the same time frame, according to the Joint Tax Committee.

BABs dealt setback in Senate fight over job bill

The U.S. Senate’s failure to pass legislation extending unemployment benefits also set back efforts to prolong the Build America Bond program, the fastest- growing part of the $2.8 trillion municipal securities market.

The effort to keep the expiring Build America program alive through 2012 was included in the unemployment bill rejected by Senate Republicans yesterday. The measure passed the House of Representatives last month.

Build America securities were created last year as part of President Barack Obama’s economic-stimulus package to help ease borrowing by state and local governments. The program is set to expire Dec. 31. Failure to extend it may dampen investor interest in the debt by limiting the size of the market, said John Hallacy, a municipal strategist in New York for Bank of America Merrill Lynch.

“The market is a little unsettled because of it,” Hallacy said in an interview today. “There’s an antispending sentiment developing in Congress and people are wondering if the extension is going to get caught up in it.”

The extra yield on Build America Bonds above U.S. Treasuries has risen to about 1.9 percentage points from about 1.5 percentage points in May, according to a Bank of America research note sent to clients today. Hallacy attributed some of that jump to concern that the extension would fail, which could make the securities more difficult to resell after the legislation lapses.

House approves extension of BABs

The House on Friday voted 215 to 204 to approve legislation that would extend the Build America Bond program for two years, while gradually reducing the subsidy payments the federal government makes to BAB issuers.

The American Jobs and Closing Tax Loopholes Act also would extend by one year the relaxed small issuer requirement for bank-qualified bonds; authorize an additional $25 billion of recovery zone bonds to be issued through 2011; exclude water and sewer exempt-facility bonds from state volume caps; and exempt private-activity bonds from the alternative minimum tax through 2011.

Further, it would provide an additional $521 million of highway funds to states.

The House sent the bill, which had been pared down from the version proposed last week, to the Senate. But that chamber had already left town for its Memorial Day recess and will not be able to take up the measure until after it returns on June 7. The Senate is expected to make further changes to the legislation.

The House measure would extend the BAB program created by the American Recovery and Reinvestment Act for two years through 2012, while lowering the subsidy payments the federal government makes to issuers from the current 35% of interest costs to 32% in 2011 and 30% in 2012.

Obama wants BABs made permanent

The Obama administration will recommend making permanent the Build America Bonds program in its fiscal 2011 budget proposal Monday, a Treasury spokesperson said Friday night.

The plan would reduce the subsidy from 35% to 28% beginning Jan. 1, 2011, but would greatly expand the program’s reach to include refundings, working capital, as well as permitting nonprofit hospitals and universities to issue the debt. The lower subsidy is intended to make the program’s cost equivalent to the cost to the federal government of traditional tax-exempt bonds.

“Build America Bonds were an important new reform in the Recovery Act. They were successful in helping to repair a severely damaged municipal finance market, making much needed credit available at lower borrowing costs for infrastructure projects that create jobs,” said Treasury Secretary Tim Geithner in a statement sent to The Bond Buyer.

“By making Build America Bonds a permanent and expanded financing tool for state and local governments, we’re investing in our country’s long term economic growth in a cost-effective way.”

Under current law, the program is slated to expire at the end of the year.

Michael Decker, managing director and co-head of the Securities Industry and Financial Markets Associations’ municipal securities division, said: “BABs have become an extremely important tool for state and local governments and we’re happy the administration has proposed making this a permanent part of the municipal market. We look forward to working with the administration and Congress to see the proposal enacted.”

Decker said that there was a widespread view in the market that the 35% subsidy rate was a reaction to very constrained credit market conditions one year ago and that there was an expectation that if the program were extended, it would be at a lower subsidy level.

But Frank Hoadley, Wisconsin’s state capital finance director and chair of the Government Finance Officers Association’s debt committee, said that in today’s marketplace, BAB maturities will “dramatically drop off” with a 28% subsidy.

“It seems to me only the highest interest-rate bonds – or low credit bonds – would have enough benefit,” he said. “High grade bonds like state of Wisconsin general obligation debt, I don’t think they’d work at 28%.”

Hoadley stressed, however, that Treasury is “absolutely correct” that BABs have been a very valuable tool under the existing authorization.

In a statement, Michael Nicholas, chief executive officer of the Regional Bond Dealers Association, said: “We fully support making the Build America Bonds program permanent and expanding this program and are pleased with the administration’s proposals.”

Nicholas noted that the BAB program has been “a great success” equaling roughly 16% of total issuance in 2009 with more expected in 2010.

“The RBDA is supportive of a variety of financing alternatives for state and local issuers and also would encourage making permanent the increase in the bank qualified limit, the AMT relief for private activity bonds and the provision allowing banks to hold up to 2% of assets in municipal securities.”

Asked if stimulus provisions encouraging banks to purchase bank-qualified debt would be extended, a Treasury Department spokesperson would not comment.

Total BAB issuance from April 15, 2009, through Jan. 28, is $70.983 billion, across 878 issues, according to data from Thomson Reuters. In January alone, issuers sold $6.862 billion of BABs across 87 issues.

The Joint Tax Committee, in a report on the stimulus law, last year estimated that BABs would result in lost revenue of $4.3 billion through 2019. On Tuesday, the Congressional Budget Office said that the popularity of the BAB program is expected to cost $26 billion more over the next 10 years than originally predicted.

Temporary BAB extension to 2012 proposed

Leaders of the House and Senate tax-writing committees yesterday planned to unveil legislation that would temporarily extend the Build America Bond program as well as several other municipal bond provisions set to expire at the end of the year.

Senate Finance Committee chairman Max Baucus, D-Mont., and House Ways and Means Committee chairman Sander Levin, D-Mich., released a summary of the American Jobs and Closing Tax Loopholes Act that would extend the BAB program to 2012 and gradually reduce its subsidy payment rate to 30% from 35%.

The legislation is to be introduced as an amendment to the so-called extenders package that preserved several expiring or expired tax breaks. The House and Senate each approved extenders bills but had not resolved their differences. The amendment also would include provisions found in a jobs bill that was passed by the House in March but has since stalled in the Senate.

The proposed BAB extension would be three months shorter than the one previously approved by the House in an earlier jobs bill. That bill would have extended BABs until April 1, 2013, and lowered the subsidy payment rate to 30% over the three-year period.

Wyden and Gregg propose the elimination of tax exempt bonds

WASHINGTON — Sens. Ron Wyden, D-Ore., and Judd Gregg, R-N.H., said they included provisions to halt the issuance of tax-exempt bonds beginning in 2011 in their tax reform bill to make the tax code fairer for all investors and to help offset proposed revenue losers.

They issued a joint statement yesterday to explain the rationale for the provisions, under which issuers would stop issuing tax-exempt bonds and instead begin issuing taxable tax-credit bonds that provide investors with tax credits equaling 25% of interest costs. The bill also would prohibit advance refundings.

“Wyden-Gregg changes tax-exempt bonds to tax-credit bonds as part of its overall effort to lower tax rates by broadening the tax base. This was a sensible option for not only broadening the base but for making the tax code more equitable, because — unlike a tax exemption — a tax credit allows taxpayers at all income levels to realize the same tax benefits,” they said.

“Overall, the significant reduction in tax rates made possible under Wyden-Gregg will give a much-needed boost to individuals and businesses across the board. Not everyone will be happy with the revenue offsets in the bill, but [we] believe they are worthwhile since they allow a much more favorable tax climate that will encourage job creation and economic growth.”

The bill has drawn strong opposition from several municipal market groups that point out the existing tax-credit bond programs have never really taken off in the market for many reasons, including that they create administrative headaches and that investors’ need for tax credits vary from year to year.

Meanwhile, the Senate’s top Republican tax writer has asked Goldman, Sachs & Co. whether it is collecting “double-digit underwriting fees” for participating in the Build America Bond program.

Sen. Charles Grassley, the ranking minority member of the Senate Finance Committee, posed the question in a letter sent late Wednesday to Goldman chairman Lloyd Blankfein. The letter asks how much the firm made underwriting BABs, how the fees were determined, and whether it made more money underwriting BABs than traditional tax-exempt bonds.

“I’m interested in finding out whether the big Wall Street investment banks being so involved in, and profiting from, the [BAB] program siphons off a lot of taxpayer dollars that are meant to help cities and states,” he said.

The Iowa Republican noted in his letter that BABs are likely going to grow in significance in the future, given that both the House and Senate have approved expansions to the program in their respective jobs bills, and the Obama administration has recommended making BABs permanent at a reduced subsidy rate.

Grassley was spurred to make the request after some market participants suggested that issuers were paying more to underwriters for BABs than tax-exempt bonds and Goldman purchased a full-page advertisement in a Washington newspaper calling itself one of the principal underwriters of BABs, his office said.

A spokesman for Goldman Sachs responded to the Grassley letter yesterday, saying BABs are a relatively new tool, various factors go into determining underwriting fees, and banks have to compete for BAB business.

“[BAB] underwriting fees are typically lower than investment-grade corporate bonds of similar maturities and slightly higher than similar maturity tax-exempt securities. Bond underwriting fees are determined by a variety of factors — complexity of the financing, credit quality and ratings, maturity, deal size, breadth of distribution required are among the key factors,” said spokesman Michael Duvally.

“BABs are a new product, which have opened up an entirely new investor base for municipal bonds, which has helped municipalities lower their borrowing costs,” he said. “While Goldman Sachs is a prominent underwriter of Build America Bonds, there are a dozen other banks that compete for business and fees, which are publicly disclosed and set on the basis of that competition.”

Meanwhile, a draft version of Senate Majority Leader Harry Reid’s “extenders” package emerged this week and includes a number of muni bond provisions.

The draft provisions mirror those originally included in a large jobs bill drafted by Senate Finance Committee chairman Max Baucus, D-Mont., and Grassley, but the Reid split the legislation into two parts. The first part — which would expand the BAB-like interest subsidy to four tax-credit bond programs at reduced subsidy levels and extend surface transportation laws — was included in a bill approved by the Senate Wednesday.

A spokesman for Reid earlier this week said the plan was to consider the bill after the Senate cleared a more immediate package of short-term tax extensions — none involving munis — and a travel promotion bill.

Grassley says banks increase fees on BABs

"Sen. Charles Grassley is opposing the expanded bond provisions included in the jobs bill the House passed Thursday, arguing that the higher subsidy rates in the legislation will just boost profits for Wall Street underwriters.

The Iowa Republican, the ranking minority member on the Senate Finance Committee, issued a statement hours after the House passed the bill late Thursday, contending that the deeper subsidies will allow underwriters to “skim the cream” by charging higher fees to municipal bond issuers.

“With its vote today, the House has one-upped the Senate majority on directing more money to profits for big Wall Street banks, while claiming to pass legislation to create jobs,” Grassley said. “The truth is, school kids and green-energy efforts get what’s left after the bank fees are paid and city and state governments have released the funding.”

He also pointed out that the House would spend over $2 billion more on the Build America Bond provisions over the next 10 years.

The Joint Tax Committee scored the costs of the Senate provisions at $2.5 billion, while the House version is estimated to cost $4.6 billion through 2020.

The Senate is expected to take up to jobs measure sometime this week, after it clears “extenders” legislation.

Last month, Grassley asked Goldman, Sachs & Co. for information regarding how much it made selling BABs and how that compared to traditional tax-exempt bonds.

“I’m interested in finding out whether the big Wall Street investment banks being so involved in, and profiting from, the [BAB] program siphons off a lot of taxpayer dollars that are meant to help cities and states,” he said at the time, noting that BABs will likely become more significant in the future as the program is extended and expanded.

The House’s version of the jobs bill would allow issuers of four types of tax-credit bonds — qualified school construction bonds, qualified zone academy bonds, new clean renewable energy bonds, and qualified energy conservation bonds — to opt to receive direct-payment subsidies as opposed to receiving that subsidy in the form of tax credits provided to investors.

Under the measure, issuers of the bonds would receive direct payments that are roughly equal to the credit rate currently on the bonds — 100% of interest costs for QSCBs and QZABs, and 70% for new CREBs and QECBs.

Although the bill the Senate passed last month also extend Build America Bond-style subsidies to those programs, it offered significantly lower subsidy rates.

Under that version, large issuers would receive a subsidy rate of 45% of interest costs and small issuers would receive a 65% rate.

The bill defined small issuers as those that sell less than $30 million of bonds in the calendar year.

However, several muni market groups have spoken out against the Senate bill and in favor of the higher rates the House is pushing.

Under the Senate plan, the groups argued, no issuers would be willing to go the direct-subsidy route if it meant receiving half of the subsidy that could be obtained with tax credits.

“The RBDA is encouraged by House passage of [the jobs bill] and its provisions to allow the conversion of tax-credit bonds to BABs,” said Mike Nicholas, chief executive officer of the Regional Bond Dealers Association. “We think this is a positive first step in expanding the vibrant market for tax-exempt securities.”

And Ken Bentsen Jr., executive vice president of the Securities Industry and Financial Markets Association, told lawmakers in a letter that the House provisions enable “state and local school districts and governments ... to achieve the no-cost or low-cost financing that Congress originally intended, similar to the highly successful Build America Bonds (“BABs”) program.”

Grassley asks Goldman to explain ‘Build America’ fees

Senator Charles E. Grassley of Iowa has asked Goldman Sachs to clarify how much it has collected in underwriting fees as states and cities issue so-called Build America Bonds to raise money for infrastructure projects and create jobs.

The senator, the senior Republican on the Finance Committee, said Wednesday in a letter addressed to Chief Executive Lloyd C. Blankfein that he was “concerned that American taxpayers are subsidizing larger underwriting fees for Wall Street investment banks, including Goldman Sachs, as a result of the Build America Bonds program.” (Read the letter after the jump.)

The bond program, part of stimulus legislation passed last year, is intended to help local governments raise money by issuing taxable bonds; the federal government subsidizes 35 percent of the interest payments. On Wednesday, the Senate passed a bill that would expand the program and its subsidies.

But the lower interest payments may have given underwriters room to charge more, even as governments still saved money compared to other debt issues.

In November, nine months after the bond program was enacted, data compiled by Bloomberg News showed that local governments were paying underwriters 37 percent more in fees to issue Build America Bonds than they were paying on tax-exempt debt, which local governments usually issue to fund infrastructure projects. The news service calculated that the extra fees amounted to $100 million at the time. In addition to Goldman Sachs, JPMorgan Chase, Bank of America and Citigroup are the top underwriters of Build America Bonds, Bloomberg data show.

Matt Fabian, managing director of Municipal Market Advisors, was cited by Senator Grassley as saying in the Bloomberg article that “the large subsidy gives them leeway to charge more because the issuer probably cares less about the underwriting fee.”

Senator Grassley’s letter included a series of pointed questions about how much Goldman has earned underwriting the subsidized debt, how it determines it fees, and what it expects to earn under the expanded federal program.

“Are these underwriting fees larger than the underwriting fees that Goldman Sachs has charged on tax-exempt bond issuances?” he asked.

A Goldman Sachs spokesperson was not immediately available for comment.

On Tuesday, a day before the expanded bond program passed the Senate, Goldman Sachs ran an advertisement in Politico claiming the bank was its “one of the principal underwriters,” according to the letter.

Goldman has vocally backed the program for months. In a Forbes commentary in November, Jim Esposito, a managing director at the bank, supported expanding the Build America Bonds, or BABs.

“BABs are a win for taxpayers, for state and local governments, for investors, for job creation, for the economy and, by extension, for America’s future,” he wrote. “The benefits to extending and expanding the program would reverberate widely and help sustain the country’s economic recovery while investing in our future.”

Wyden proposes different "flavors" of BABs

Sales of Build America Bonds, the fastest-growing part of the U.S. municipal debt market, may double to $130 billion in 2010 as states and cities rush to borrow before Congress can change federal subsidies.

Lawmakers might retool the program to treat transportation debt more generously than other issues, Ron Wyden, the Oregon Democratic senator who proposed the bonds as an “experiment” six years ago, said in an interview. The U.S. government pays 35 percent of interest costs on taxable borrowing for local public works.

“There’s going to be some discussion of whether there ought to be different flavors of Build America Bonds,” said Wyden, who originally estimated the measure, authorized this year as part of President Barack Obama’s economic-stimulus program, would create $4 billion to $5 billion in securities. “There will inevitably be a debate about cost.”

After reaching $64.3 billion since offerings began in April, new issues of Build America Bonds will more than double to $130 billion in 2010, equivalent to 30 percent of next year’s total sales of municipal debt, according to Loop Capital Markets, a Chicago-based investment bank and municipal underwriter.

The surge may be fueled by state and local governments racing to borrow “if it seems likely that the level of the BAB subsidy will be reduced” after the current program expires on Dec. 31, 2010, George Friedlander, a Morgan Stanley Smith Barney strategist, said in a research note Dec. 18.

$1.38 Billion

Congress will probably focus on adjusting the 35 percent subsidy as part of a broader debate over closing a federal deficit that will exceed $1 trillion, Wyden said. Build America Bonds issued in 2009 will cost the U.S. about $1.38 billion in gross subsidies each year the debt is outstanding, based on data compiled by Bloomberg. The expense would be reduced by taxes investors may pay.

The congressional Joint Committee on Taxation initially estimated the program would cost U.S. taxpayers $53 million in the fiscal year ended Sept. 30, $323 million in fiscal 2010 and $506 million over the next 12 months before starting to decline, according to a document dated Feb. 12.

States and municipalities opt to sell Build America Bonds to fund roads, schools and sewers when their after-subsidy cost of capital is lower than what they would get from issuing tax- exempt debt.

‘We’re Delighted’

Washington state’s first Build America sale on Oct. 15 produced what Treasurer James McIntire called a record-low effective yield of 3.52 percent on $503.4 million of bonds. The estimated savings of $62.4 million over the life of the securities would be enough to buy a passenger ferry, McIntire said. “We’re delighted.”

The BofA Merrill Lynch Build America Bond Index has increased 1.3 percent, including reinvested interest, since its inception April 30.

Build America Bond issues have become a “one-for-one transfer” of sales from the tax-exempt market, Loop Capital strategist Chris Mier and analyst Ivan Gulich said in their Dec. 22 forecast.

The relative scarcity of long-term, tax-free securities helped to push the Bond Buyer 20 index of yields on 20-year general obligation bonds to 4.21 percent last week from 5 percent at the end of March. A 42-year low of 3.94 percent was reached Oct. 1.

Description of program

Source: US Treasury description

The existing tax-exempt bond market has faced significant challenges over the past two years. The Build America Bonds address that by providing state and local governments with a new, optional, alterative direct federal payment subsidy for a portion of their borrowing costs on taxable bonds.

"Increasing state and local funding for capital projects doesn't just help rebuild our aging infrastructure. It gets American's back to work," said Treasury Secretary Tim Geithner. "Build America Bonds is an innovative approach to augment the ailing tax-exempt bond market and shows the Administration's commitment to economic recovery for Main Street."

Build America Bonds provide a deeper federal subsidy to state and local governments (equal to 35 percent of the taxable borrowing cost) than traditional tax-exempt bonds and because of this federal subsidy payment, state and local governments will have lower net borrowing costs.

Also, this feature should make such Build America Bonds attractive to a broader group of investors than typically invest in more traditional state and local tax-exempt bonds.

A simple example: If a state or local government were to issue a Build America Bond and paid to the bondholder $100 of interest on the bond, the Treasury Department would make a payment directly to the state or local government of $35. Thus, the state or local government's net interest expense would be only $65 on a bond that actually pays $100 to the bondholder.

The capital projects these bonds would fund include work on public buildings, courthouses, schools, transportation infrastructure, government hospitals, public safety facilities and equipment, water and sewer projects, environmental projects, energy projects, government housing projects and public utilities.

School Bonds

In addition, Treasury also announces guidance on allocations of national bond volume cap authorizations for two innovative tax credit bond programs for schools, known as Qualified School Construction Bonds and Qualified Zone Academy Bonds. The American Recovery and Reinvestment Act of 2009 provided new or expanded authorizations, respectively, for these two programs. These tax credit bond programs allow state and local governments to finance authorized public school construction projects and other eligible costs for public schools with interest-free borrowings. These tax credit bond programs provide this federal subsidy to state and local governments for their borrowing costs by giving investors a federal tax credit in an amount designed to replace 100 percent of the interest payments on the bonds. As a result, state and local governments are able to issue these bonds without interest cost.

The guidance that Treasury and the IRS are issuing today allocates the national bond volume authority for these school bond programs among the States and certain large local school districts under statutory formula. These volume cap allocations are important to enable state and local governments to use these low-cost borrowing programs to finance school projects to promote economic recovery and job creation.

For Qualified School Construction Bonds, the guidance provides for division of the $11 billion national bond volume authorization for 2009 among the states and 100 largest school districts based on levels of Federal school funding.

For Qualified Zone Academy Bonds, the guidance provides for division of the $1.4 billion national bond volume authorizations for each of 2008 and 2009 among the states based on poverty levels.

Treasury releases Build America Bonds update

WASHINGTON – The Treasury Department today released its monthly comprehensive update on issuances of the Build America Bonds program, including state-by-state data. The Build America Bonds program is a financing tool created by the American Recovery and Reinvestment Act to allow state and local governments to obtain much-needed funding, at lower borrowing costs, for new capital projects such as construction of schools and hospitals, development of transportation infrastructure, and water and sewer upgrades.

Build America Bonds, which are taxable bonds, are designed to appeal to a broader set of investors than traditional tax-exempt bonds. Under the Build America Bonds program, the Treasury Department makes a direct payment to the state or local governmental issuer in an amount equal to 35 percent of the interest payment on the Build America Bonds. Potential new investors include pension funds that typically do not hold tax exempt bonds and foreign investors. These investors have been important additions to the market for municipal debt.

"Build America Bonds have changed the landscape of the municipal bond market by opening it to a broader range of investors," said Alan B. Krueger, Assistant Secretary for Economic Policy at the Treasury Department. "Expanding and making this program permanent, as the President proposed in the budget, will further improve the long-term functioning of the municipal bonds market."

The Obama Administration's FY 2011 budget proposes to make Build America Bonds permanent with a 28 percent subsidy rate; this rate is estimated to be revenue neutral relative to the estimated future Federal tax expenditure for tax-exempt bonds. The budget also proposes expanding the eligible uses of Build America Bonds to cover a wider range of municipal borrowing, including original financings for public capital projects, current refundings for public capital projects, short-term working capital, and nonprofit 501(c)(3) organization financings.

Market reception for Build America Bonds has been very positive. Between the program launch on April 3, 2009 and February 28, 2010:

  • There have been nearly $78 billion in Build America Bond issuances;
  • Build America Bonds now constitute about 20 percent of the municipal bonds market; and
  • There have been a total of 929 separate issues of Build America Bonds by local or state governments in 47 states.

Issuance levels

Higher underwriting fees charged

"States and municipalities paid an average 37 percent more to investment banks for underwriting Build America Bonds than for handling tax-exempt sales since offerings of the subsidized taxable debt began in April.

Municipal issuers compensated underwriters at an average $7.39 per $1,000 for sales involving Build America Bonds and $5.40 for tax-exempt deals, based on data compiled by Bloomberg from a sampling of $40 billion of each type. Across the $55 billion in so-called BABs sold so far, the difference translates to more than $100 million in added costs. Both fee rates exceed this year’s $4.91 corporate average.

Local government officials accepted higher fees from banks marketing the new product, which provides a 35 percent federal interest subsidy under President Barack Obama administration’s stimulus initiative. Issuers obtained lower net borrowing costs than from traditional tax-exempt financing, and the program’s advent helped reduce yields in the broader municipal market.

“The large subsidy gives them leeway to charge more because the issuer probably cares less about the underwriting fee,” said Matt Fabian, managing director and senior analyst at Concord, Massachusetts-based independent research firm Municipal Market Advisors. “They shouldn’t care because federal taxpayers will cover the difference. As a federal taxpayer, I’m highly concerned.”

Nine Football Fields

The $100 million in added fees would be enough to build about 500,000 square feet (46,451 square meters) of high school space, based on average construction costs for New York City cited by Reed Construction Data in September. The area equals almost nine football fields.

The American Recovery and Reinvestment Act, enacted in February, allows state and local governments to raise money for infrastructure projects that would otherwise be deemed tax- exempt by selling an unlimited amount of federally subsidized, taxable bonds through 2010. Refinancing existing long-term, tax- exempt bonds with Build America deals isn’t allowed.

...Created under the stimulus act, BABs (Build America bonds) allow municipalities to sell taxable munis and in lieu of the traditional tax exemption receive a subsidy from the federal government equal to 35% of the interest costs.

Issuers have sold $26.75 billion of BABs since the launch of the program in April, according to Bloomberg LP.

Bankers have charged more to underwrite BABs — an average of $8.04 per $1,000 face, compared with $6.27 for other munis, according to Thomson.

The crisis also knocked out a pillar of demand in municipals.

Earlier this decade, a group of hedge funds was buying munis to arbitrage what they perceived as irrationally high yields on long-term munis.

The arbitrage strategy required a complex hedging system using derivatives. The hedges assumed a stable relationship between tax-exempt yields and certain taxable yields, like the London Interbank Offered Rate or Treasury yields.

The flight to safety last year disrupted these relationships and many of the funds were forced to liquidate their positions after the hedges failed. As a result, a major contingent of buyers for munis vanished.

“They were really driving the demand side of the equation,” Yosca said of the municipal arbitrage funds. “That buy-side component seems to be a thing of the past now, so you’ve got to find alternative places to put the bonds.”

BAB index created

Source: Wells Fargo Launches Index To Track BAB Performance August 26, 2009, Bond Buyer

"Wells Fargo & Co. has launched an index tracking the performance of Build America Bonds, the hottest sector in government finance.

The Wells Fargo Build America Bond Index measures total returns on big, liquid BAB issues.

To be eligible for inclusion, a BAB must have at least $100 million in par value, mature in a year or more, pay a fixed rate and not be in default.

The index, which was first published Monday, currently is made up of 29 securities. The index value kicked off at 100, retroactively to May 1, and has since climbed to about 107.

Dan Forth, head of strategic indexing for Wells Fargo, called the index a "vital step" in the evolution of BABs. The index will help educate investors, provide transparency and enable people to monitor the market, he said.

"We believe it's an important evolution in the market, given the concern over the future funding requirements of municipal entities," Forth said.

The index weights the included securities by market value, and determines prices from observed secondary trades combined with inputs from the Bloomberg relative value model.

The Bloomberg model ascertains what a municipal bond should trade at, based on comparisons with bonds of similar credit quality and size.

BABs were created through the American Recovery and Reinvestment Act, which President Obama signed into law in February.

In lieu of the traditional tax exemption on municipal debt, state and local governments can sell taxable bonds and collect a federal subsidy equal to 35% of the interest costs.

The program is designed to allow municipalities to float bonds to investors who do not pay taxes and thus have no reason to bid on tax-exempt paper.

Since the first BABs hit the market in April, issuers have sold $26.92 billion of the bonds, according to Bloomberg.

The pricing and liquidity of BABs is a crucial matter for local governments.

Governments that need to raise money often face a choice: sell tax-exempt bonds at one interest rate or sell taxable bonds at a rate that is nominally higher. Under the BAB program that rate is potentially lower after the federal subsidy. The more aggressively BABs price, the less cost-effective tax-exempt financing will seem.

Some have speculated the federal government created BABs as a test to see whether the municipal finance market could be viable without the tax exemption.

The pricing of BABs has therefore been of great interest to the municipal market.

Some issuers faced questions about the pricing of their deals. Some have said they agreed to pay too much interest on their debt, considering yields on some of the first BABs dropped sharply and immediately after issuance.

Many investors have compared BAB yields with yields on corporate bonds, or sovereign bonds from other countries.

Bank of America/Merrill Lynch municipal strategist Phil Fischer has created an informal BAB index, averaging the yields on some of the biggest issuers.

Total return is one of 12 attributes Wells Fargo measures with its indexes. Others include modified duration, option-adjusted spread over Treasuries, and average yield.

Six are available on Bloomberg now, under the function "BABS Index." Forth said the other six will be available by Friday.

Forth has been creating indexes for eight years, and said he has created more than 50. His career constructing indexes began when he worked in bond origination, and constructed proprietary indexes to track the markets he was involved in.

The Build America Bonds program will sunset next year absent an extension by Congress.

If it does continue, the index can continue to develop as the number of deals eligible for inclusion grows, Forth said. He pointed out some indexes are comprised of thousands of securities."

BABs fuel excessive and unwise government investments

"...All these debt-enabled abuses—extravagant spending, concealments of budgetary problems, and risky investment strategies—came to a head in the second half of 2008, when spooked investors withdrew from the muni-bond market in droves. A downturn in tax revenues had revealed how little breathing room some local governments had left themselves to pay their debts; also, several insurers that typically backed muni bonds had exited the market, leaving buyers unprotected against defaults. The investors' flight should have signaled to cities and states that it was past time to reform their debt practices.

Instead, the federal government reopened the muni-bond business by stepping in with a new kind of municipal offering, the Build America Bond, which is taxable but can offer an attractively high interest rate because it's partly subsidized by Washington. Municipalities enthusiastically embraced the new bonds, racking up another $58 billion in debt in 2009. It's no surprise that the states in the worst fiscal shape, thanks partly to previous borrowing, made the biggest use of the bonds; California led the pack.

Build America Bonds have worsened what economists describe as a misallocation of resources that results from municipal debt's favored status. Muni bonds are usually tax-free, and numerous studies have estimated that of the enormous tax revenues forgone by the government, 20 to 33 percent goes to the bond buyers, who tend to be high-income individuals. That's a huge incentive not to invest in the private sector by buying, say, corporate bonds or equities. Economist Peter Fortune estimated in the early nineties that the misallocation reduced private-sector output by billions of dollars a year; the amount is obviously far larger now. The introduction of Build America Bonds, attracting a whole new class of investor with subsidized interest rates, will make the misallocation even greater.

The current crisis in state and local budgets may be the best opportunity in ages to bring reform to the muni market. Critics have argued in the past that the government should abolish the federal-tax-exempt status of municipal bonds. Those arguments have gone nowhere because the market has powerful defenders: the Wall Street firms that earn underwriting fees selling bonds; the investors benefiting from subsidies; and state and local politicians making liberal use of the debt...."

Types of projects

Source: Reuters, July 3, 2009

As of June 11, 2009:

  • 45% percent for general public improvement projects
  • 30% for transportation
  • 16% for education

Thomson Reuters data shows that all stimulus-related bonds, which include school and energy debt, totaled $15.7 billion in 148 deals in the first half of 2009. The stimulus plan also included tax credit energy and school bonds, as well as debt structured similarly to BABs to be used for economic recoveries.

Tax treatment

IRS Issues Guidance on New Build America Bonds

IRS backs away from plan to audit tons of BAB deals

Officials at the Internal Revenue Service previously said the agency planned to audit as many as half of all Build America Bonds deals, but they are backing away from that comment, apparently in a concession to issuers. Such an enforcement effort raises concern that municipalities might be discouraged from selling BABs. IRS officials said it is too soon to know how many deals will be audited. "Right now, to say exactly that we have the percentage or that we have a target in mind, I think that's inaccurate," said Steven Miller, deputy commissioner for services and enforcement at the IRS. "It's way too early."

IRS plans to audit up to half of BABs deals

The U.S. Internal Revenue Service plans to examine as many as half of the 1,200 Build America Bond sales in connection with rules that limit how the subsidized issues can be used and how much they cost, according to an agency compliance manager.

The reviews are a follow-up to a questionnaire the tax service began distributing to issuers in February, seeking information on record-keeping and the steps public borrowers have taken to ensure they get proper rates, Steven Chamberlin, compliance manager in the agency’s tax-exempt bond unit, said on a May 25 conference call. The call was set up by the National Association of Bond Lawyers in Chicago.

“The second stage will be a follow-up, focused-examination project of potentially half of all Build America Bond transactions,” Chamberlin said on the call. “An examination is looking at a specific return and may involve looking at underlying documentation with respect to that specific return.”

The agency yesterday posted on its website a revised questionnaire, for use starting next month. In an accompanying announcement, the service said it was changed to “ensure that the questions are clearly interpreted and to request expanded descriptions of the issuer’s compliance procedures and practices.”

The Internal Revenue Service plans to audit some Build America Bond issues to determine if they meet the tax requirement on issue price, an agency official said here last week.

“We will be sending out examinations and we will be sending out [information document requests] to specifically inquire about compliance with this requirement,” said Steve Chamberlin, senior manager of compliance and management in the IRS’ office of tax-exempt bonds. But he said the IRS has not yet determined how the BABs will be selected for audits.

Chamberlin made the remark at the National Association of Bond Lawyers’ Tax and Securities Law Institute after bond lawyers raised questions about why the “compliance check questionnaires” the IRS recently sent to BAB issuers asks whether they follow secondary market trading activity for their BABs after the sale date.

The four-page survey was sent to issuers beginning last week, but was not publicly released until late Thursday,

“Every single issuer of BABs, whether they issued one BAB or 10 BABs, they will get a questionnaire,” Chamberlin told the lawyers at the meeting.

The questionnaire asks issuers if they know whether information about the secondary market trading activity of their BABs is available through the Municipal Securities Rulemaking Board’s Electronic Municipal Market Access system.

t also asks if the issuer or a consultant, other than the underwriter or initial bond purchaser, reviewed secondary market activity after the sale date of the bonds but before the date of issue. Another question asks the issuer if it found that its bonds traded for a higher price before the issue date.

Those questions appear to be seeking information regarding “flipping,” which occurs when dealers or institutional investors purchase bonds and then immediately resell them to retail investors at a higher price.

But bond attorneys pointed out that, as far as the federal tax requirements are concerned, the issue price is determined once 10% of the bonds have been sold at that price..."

"Flipping" of BABs

"New Jersey’s pension fund, facing a $46 billion deficit, is bolstering its finances by buying Build America Bonds from the state’s debt underwriters, then selling them for a profit in as little as five days, state records show.

The pension, whose $700 million in Build America investments would make it the seventh-largest holder of the bonds, earned $2.6 million in the past year by rapidly buying and selling, or flipping, the taxable debt issued by municipalities across the U.S., according to data compiled by Bloomberg.

New Jersey’s ability to turn profits 17 times in five months or less shows how some borrowers in the $93.4 billion Build America market may be selling bonds at a higher cost to taxpayers than necessary, said Robert Lamb, a professor at New York University’s Stern School of Business.

“This is supposed to be a wash,” said Lamb, who serves on the board of editors of the Municipal Finance Journal, a scholarly quarterly. “The fact they are making a market in this fashion so quickly with, it appears, little added value certainly raises certain ethical questions and may involve legal issues.”

Flipping is under review by the Internal Revenue Service because the U.S. Treasury subsidizes 35 percent of Build America costs. The Municipal Securities Rulemaking Board, the market’s self-regulator, is considering restrictions on how underwriters allocate the bonds among institutional and individual buyers...."

Lawyers push to use tax exempt debt to refund BABs

"U.S. tax lawyers are pressing the Internal Revenue Service to clarify whether issuers of taxable Build America Bonds can use tax-exempt debt to refund the bonds, a move that could save issuers millions.

'We read the rules as allowing tax-exempt bonds to be used to refund BABs if the general tax-exempt bond requirements are met,' the American Bar Association's tax committee said in commentary released on Friday.

'Again, for the avoidance of doubt in the marketplace, we believe this result should be confirmed.'

The marketplace is eager to settle the question around the bonds, which were created in the economic stimulus plan passed in February, because issuers would get a 'deeper subsidy,' Jeremy Spector, chair of the committee, told Reuters.

BABs are taxable debt that give issuers federal subsidies equal to 35 percent of the interest costs. Taxable rates are generally higher than tax-exempt ones.

The bonds are largely credited with thawing the frozen municipal bond market this year, with the subsidy allowing cash-strapped states and cities to take out cheap credit.

An issuer could sell BABs, collect the subsidy and then issue tax-exempt bonds to advance refund the BABs. The interest they would pay on the refunding bonds would be lower, Spector said, and it would be further depressed by the subsidy.

Spector gave an example of a Build America Bond paying 5 percent interest that an issuer refunds with a tax-exempt bond that pays 4 percent interest.

'The issuer enjoys a 35 percent subsidy based on the 5 percent rate of the taxable rate,' while paying the 4 percent tax-exempt rate, he said, which translates into a 1.75 percent subsidy.

There is nothing in the American Recovery and Reinvestment Act barring issuers from refunding BABs, Spector said. Since the law was signed underwriters and issuers have pressed for guidance from the federal government. So far, they have not had any clarification and some have suggested that it is a matter for the U.S. Congress.

The committee also pressed the IRS to speed up its timeline for issuing guidance on stripping tax credits from some stimulus bonds.

The plan included a handful of new bonding programs where the debt buyer receives a credit against federal tax payments in lieu of an interest payment. The holder can sell the credit -- or 'strip' it -- while still holding on to the principal.

'Treasury hopes that a market will develop,' for the credits, said Spector, although it has yet to explain the mechanics of trading those credits.


"State and local governments, forced to close budget gaps by firing workers and shutting schools, may pay at least $4.2 billion more in interest than companies with similar credit ratings on Barack Obama’s Build America Bonds.

The $17.4 billion of Build America Bonds sold since April pay an average yield that’s 0.96 percentage point more than corporate securities with the same ratings, according to data compiled by Bloomberg and based on the 25 largest deals.

“Taxpayers are taking it on the chin,” said G. Joseph McLiney, president of Kansas City, Missouri-based McLiney & Co., a firm that specializes in selling municipal bonds that qualify for federal tax credits. “There should be no spread.”

While Build America Bonds opened credit markets to municipalities after the collapse of Lehman Brothers Holdings Inc., states and cities are being penalized compared with corporations, which are 90 times more likely to default than local governments, according to Moody’s Investors Service.

The Indiana Finance Authority sold $191.6 million of the debt on June 23 that was rated Aa3 by Moody’s Investors Service and yielded 6.6 percent. The day before, Whitehouse Station, New Jersey-based drugmaker Merck & Co. issued $750 million of 30- year bonds with the same rating to yield 5.86 percent.

Indiana will pay $1.4 million more in annual interest than Merck. That’s about the amount Republican Governor Mitchell Daniels and state legislators agreed to cut from the Indiana Arts Commission as tax collections fell $1 billion during the past year.

‘Disserving Their Constituents’

The difference in borrowing costs shows elected and appointed officials are failing taxpayers, said Stanley Langbein, a banking and tax law professor at the University of Miami and former counsel at the U.S. Treasury in Washington.

Issuers are “supposed to get the best rate available,” Langbein said. “To me they’re disserving their constituents. Their responsibility is to get the lowest rate available, which is the corporate rate.”

Congress included the Build America Bonds program in the $787 billion stimulus President Obama signed into law in February, after sales of fixed-rate municipal bonds fell 17 percent last year to $281.1 billion, according to Bloomberg data. Most of the drop followed Lehman’s bankruptcy in September.

The initiative, which expires at the end of next year, provides a federal subsidy for 35 percent of the interest costs on taxable bonds sold by states, local governments and universities to finance capital projects that create jobs. Borrowers say they save money compared with tax-exempt debt because the interest after the federal payments is lower than tax-exempt benchmarks.

‘Priced it Right’

“We feel like we priced it right,” Jennifer Alvey, Indiana’s public finance director, said of the June bond sale. Indiana is paying a rate of 4.28 percent after the subsidy, lower than on tax-exempt bonds, she said. “That’s the difference I care about.”

Investors demand higher rates from municipal borrowers because Build America Bonds are 91 percent smaller than company offerings on average, according to data compiled by Bloomberg.

While California sold $5.23 billion in April, the largest issue so far, Avondale, Arizona, offered $29.8 million on July 6 for sewer and other public improvements. The average par amount for Build America Bonds is $102.5 million, compared with $1.16 billion for the 611 U.S. investment-grade corporate bond offerings this year, according to Bloomberg data.

‘Pricing Power’

Investors also require higher yields because they say the securities may become difficult to trade if the program isn’t extended past 2010, said Natalie Trevithick, a senior vice president at Pacific Investment Management Co. The Newport Beach, California-based firm runs the world’s biggest bond fund, the $161 billion Total Return Fund.

“We do have much more pricing power in these deals,” Trevithick said.

Endowments, foundations and pension funds are overlooking the securities because unlike Pimco, they don’t have expertise to analyze municipalities, said Peter Coffin, president of Boston-based Breckinridge Capital Advisors, which oversees $10 billion in bonds.

“You have a lot of big buyers so there’s less price competitiveness,” said Scott Minerd, the chief investment officer at Santa Monica, California-based Guggenheim Partners, which manages $100 billion.

Alan Krueger, the Treasury’s chief economist in Washington, said Build America Bonds succeeded in reviving the municipal market by lowering debt costs. He said municipal and corporate securities are different, so they are difficult to compare.

‘Good Start’

“Build America Bonds are doing what they were designed to do, which is lower the cost of capital for municipalities and increase access to capital markets,” Krueger said in a July 15 telephone interview. “That’s what Build America Bonds are intended to do, and they’re off to a good start doing that.”

State tax collections fell 11.7 percent to $160 billion in the first quarter compared with the same period in 2008, the largest drop in at least 46 years, the Rockefeller Institute of Government in Albany, said in a July 17 report.

Congress’s Joint Tax Committee estimated in February that the Treasury would spend $9.8 billion through 2019 subsidizing the bonds. Matt Fabian, a managing director at Municipal Market Advisors in Westport, Connecticut, said in a June 22 report that the program’s price tag may reach $27.3 billion by the time all such securities mature in 2044.

Merit Scholarships

For taxpayers in Michigan, the disparity between municipal borrowing costs and rates charged to companies might have paid for a year of university merit scholarships for high school students. Senators voted to phase out the awards to save $5.1 million this year as they battled with Democratic Governor Jennifer Granholm over the budget deficit.

Michigan, rated Aa3, sold $281.9 million of Build America Bonds on June 17 to yield 7.69 percent. Including the discounted offering price, that’s an extra $93.7 million in interest- related costs over the life of the 18-year bonds compared with Merck’s, or about $5.21 million a year.

“It was still more cost effective than tax-exempt,” said Myron Frierson, the finance and administration director in Michigan’s transportation department. “That was our goal.”

The subsidy will lower the annual rate on the bonds to “close to 5 percent,” or about 0.45 percentage point below what the state would have paid to issue tax-exempt debt, he said. The bonds are secured by annual grants the state gets from the Federal Highway Administration.

Option Costs

Michigan reserved the right to buy back the bonds at face value beginning in 2018. The so-called par call is convention in the municipal market and less common in corporate securities, said Andrew Kalotay, chief executive officer of Andrew Kalotay Associates in New York. The option may account for about 30 basis points, or 0.3 percentage point, of the extra yield.

Florida, which cut funding for housing programs and invasive plant management to balance its budget, sold $200.5 million of 30-year turnpike revenue debt last month at a yield of 6.83 percent. While the bonds are rated Aa2, one level above Merck’s securities, they pay almost 1 percentage point more in annual interest.

The spread is even wider when considering more of the smaller Build America Bond deals, according to Philip Fischer, a strategist in New York at Merrill Lynch & Co., a unit of Charlotte, North Carolina-based Bank of America. He found that on July 15 the average yield on bonds of more than $100 million compared with an index of AA corporate rates was 1.49 percentage point.

“Munis and corporates are apples and oranges in terms of the credit, but does that justify that kind of spread? Not for me,” said Ben Watkins, the director of Florida’s state bond division. Investors in the corporate bond market are “taking advantage of an opportunity.”

"The federal government may find that the cost of making direct payments to issuers is considerably higher than the “subsidy” produced by tax-exemption."

  • June 25 (Bloomberg) -- Barack Obama may be the worst thing that ever happened to tax-exempt bonds and, so far, states and municipalities are loving it.

Build America bonds, taxable securities that pay 1 percentage point more in interest than corporate debt on average, are such a hit with investors that the government is already considering expanding the program, according to John J. Cross, the Treasury’s tax legislative counsel. Municipalities sold $14.4 billion of the securities and Barclays Plc analysts predict the amount may grow 10-fold because the federal government helps pay the bonds’ interest.

The debt -- which finances everything from roads to schools to electric lines -- is helping Obama create jobs and may allow him to rein in the municipal market, where $2.7 trillion of bonds are outstanding, according to Ann-Ellen Hornidge of Mintz Levin Cohn Ferris Glovsky & Popeo PC, a law firm in Boston. Presidents since Franklin D. Roosevelt have tried to tax the interest payments from municipal bonds without success.

“There is a giant experiment going on here,” said Hornidge, whose firm advised municipalities on $4.3 billion of debt sales last year. “The Treasury has never liked tax-exempt bonds, and I think you can assume they have tax-exempt bonds in their crosshairs.”

Tom Gavin, a spokesman for Obama, said in March that the president planned a task force to “rebalance the federal tax code,” which created the current municipal market.

Obama Stimulus

Build America bonds, part of the president’s $787 billion stimulus plan, helped municipalities raise cash after the seizure in credit markets that started in August 2007, increased yields on debt due in 20 years to 6.01 percent, the highest since 2000, according to the Bond Buyer’s 20 General Obligation Bond index. Sales of fixed-rate municipal bonds fell 17 percent to $281.1 billion in 2008 from $338.2 billion the previous year, according to data compiled by Bloomberg.

The program is attractive to towns and cities because the federal government pays borrowers 35 percent of the interest cost if they issue taxable debt instead of tax-exempt securities for capital projects.

The Nebraska Public Power District sold $50 million of the notes this month to overhaul some of its 5,000 miles of electric transmission lines. The securities -- $17.5 million of 6.6 percent revenue bonds maturing in 2026 and $32.9 million of 7.4 percent debentures due in 2035 -- saved 0.61 percentage point in annual interest because of the federal subsidy, said Christine Pillen, the district’s deputy assistant treasurer in Columbus.

“It’s just bottom-line cheaper money,” she said.

Construction Jobs

More than 110 borrowers from New Jersey to California sold the securities since the first sale in April. Strategists at London-based Barclays forecast about $150 billion in taxable municipal securities will be issued before the program expires at the end of 2010.

Build America bonds are part of Obama’s efforts to lift the economy out of the deepest recession since the 1930s. The government and the Federal Reserve have agreed to lend, spend or guarantee $12.8 trillion to support the financial system. The jobless rate rose to 9.4 percent in May, the highest since 1983. Obama’s spokesman, Robert Gibbs, said this week that it will likely reach 10 percent.

The Plainfield Fire Protection District in Plainfield, Illinois, raised $8.2 million with 6.625 percent notes in April to help finance a 65,000-square-foot administration and training center. The project is creating 150 construction jobs over 15 months, according to Mark Carlson of Carlson Brothers Inc. the Joliet, Illinois-based construction manager.

Refinancing Debt

The Treasury may seek congressional authorization to extend the program instead of letting it expire at the end of next year, according to Cross, who joined the Treasury as tax counsel in 2006 from the law firm Hawkins Delafield & Wood LLP in Washington. It could also be expanded, letting states sell the bonds to refinance tax-exempt bonds, he said.

“The obvious next step in the whole thing would be: Should you make a program like this permanent?” Cross said at a bond market conference in New York on June 8 sponsored by the Securities Industry and Financial Markets Association. “Maybe it’s more successful than originally assumed.”

Alan Krueger, a Princeton University economist appointed assistant Treasury secretary by Obama this year, said the department will monitor the Build America bonds “and as we get closer to 2010 make a decision about whether we would seek to have them extended.” It is “premature to make a judgment” because the program is only two months old, he said in an interview with Bloomberg News.

Treasury’s Preference

The Treasury prefers the taxable bonds because tax-exempt debt mostly benefits investors in higher tax brackets, said Krueger, who also testified last month at a House Ways and Means subcommittee hearing on the programs. Taxable municipal securities are more “efficient” than tax-exempt, he said.

Individuals with gross incomes of more than $500,000 a year claimed 44 percent of the $72 billion in interest on municipal bonds that wasn’t taxed in 2006, according to the most recent data from the Internal Revenue Service. Of the 143 million household tax returns filed in 2007, 6.3 million claimed they received $76 billion in tax-exempt interest, up from 6 million and $73 billion in 2006.

“The federal government, like a bad house guest, is going to be reluctant to leave this market after 2010,” said Christopher Mier, a municipal bond analyst at Loop Capital Markets in Chicago. The Build America program would allow the Treasury to control how much gets allocated to subsidies during any given year, he said.

Budget Forecast

In a budget forecast in May, the administration said the government would provide $340 million next year for muni interest payments. The administration is underestimating the amount of the bonds being sold and overestimating tax collections, according to Philip Fischer, a municipal bond strategist in New York at Merrill Lynch & Co., a unit of Charlotte, North Carolina-based Bank of America Corp.

Fischer estimates the Treasury will pay about $240 million for the first $13.5 billion of bonds, subsidizing securities that have an average coupon of 7.5 percent and taxing that interest at an average 11 percent. Most of the buyers are institutions such as mutual funds and pension funds that don’t pay taxes, he said. If sales reach $80 billion, the cost of the subsidies could exceed $1 billion a year, he said.

“It’s quite good for the issuers and it brings to the market a new source of capital, but it potentially has costs that were larger than originally estimated,” Fischer said.

Not Best Rates

Even with the savings, borrowers may not be getting the best rates. New York’s Metropolitan Transportation Authority sold $750 million of the securities in April. The debt surged 8.6 cents on the dollar within two weeks, driving the yield down to 6.6 percent from 7.34 percent, according to the Municipal Securities Rulemaking Board.

The $273 million in 6.875 percent taxable bonds the New Jersey Transportation Trust Fund sold on May 25 to yield 7 percent have gained about 5 percent in price, according to MSRB data. Muni bonds maturing in more than 22 years lost 3 percent in the same period, according to Merrill Lynch & Co. index data.

Barney Frank, chairman of the House Financial Services Committee, says there’s “zero chance” Congress would permit the muni exemption to be eliminated. The Massachusetts Democrat said in an interview last month that Build America bonds can co- exist with the rest of the market.

“I don’t see one as displacing the other,” said Frank, who has sought to reform the muni market with new regulations for credit rating companies and financial advisers. He has most of his $896,000 in savings invested in tax-exempt bonds sold in Massachusetts, according to financial disclosures.

16th Amendment

“It’s been a beneficial program that has supported municipal bond issuers during this time of economic dislocation,” said Leslie Norwood, an associate general counsel at the Securities Industry and Financial Markets Association in New York. The group supports it “with the understanding that it’s a temporary program.”

Interest on state and local government bonds sold for public purposes has been exempt from federal levies since the Constitution was ratified and remained so after the 16th Amendment was approved in 1913 creating the federal income tax.

Presidents and lawmakers have tried to roll back the exemption for decades. Since the 1960s, Congress has passed legislation prohibiting use of public debt for racetracks, massage parlors, golf courses and other private purposes. The House Ways and Means Committee initially proposed subsidizing taxable municipal bonds in 1969. President Jimmy Carter and Bill Clinton also embraced the idea.

Opposing Alternatives

Municipalities opposed the efforts as well as alternatives that give the federal government more control over state and local capital spending, said Jeffrey Esser, the executive director of the Government Finance Officers Association in Chicago.

There were no hearings on Build America bonds before they debuted, so there was no opportunity to mount opposition, Esser said. States and local governments already sold some taxable debt for private projects that don’t qualify for the tax- exemption.

Investors are reaping the Build America rewards. The Utah Transit Authority, which is rated AAA, sold $261.4 million of 5.94 percent Build America securities maturing in 2039 on May 21 that yielded 6.41 percent, or 165 basis points more than Treasuries of similar maturity.

Corporate Debt Sale

Redmond, Washington-based Microsoft Corp., the world’s largest software maker, also sold bonds rated AAA in May. It paid a yield of 5.65 percent, or 90 basis points, more than Treasuries. A basis point is 0.01 percentage point.

Utah paid a higher yield even though Moody’s Investors Service says the 10-year default rate for investment grade municipal bonds it rates is 0.1 percent. For corporate debt, the overall default rate was 9.7 percent as of 2007, according to the New York-based company.

“There’s nothing to say the capital market can’t work for municipal bonds without an exemption,” said Mark Robbins, an associate professor of public policy at the University of Connecticut in West Hartford. “It looks like a whole new era in municipal finance if this thing catches on.”


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