July 22 (Bloomberg) -- 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.”

To contact the reporters on this story: Michael McDonald in Boston at mmcdonald10@bloomberg.net; Bryan Keogh in New York at bkeogh4@bloomberg.net.

Last Updated: July 22, 2009 10:04 EDT