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.”

To contact the reporters on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net.

Last Updated: June 25, 2009 10:55 EDT