Trigger Subsidy Cuts Imperiling Build America Rally: Muni Credit
Savannah, Georgia, sold $16 million of Build America Bonds three years ago to pay for work on its water system, seizing on the federal government’s promise to pay 35 percent of the interest bills.
Now, as a result of the U.S. budget stalemate, Savannah joins municipalities from Hawaii to Maine facing the prospect that the Treasury Department will welsh on obligations for the program, created by President Barack Obama’s 2009 stimulus.
Investors may be stung too: If the U.S. trims payments, some localities can repurchase the taxable bonds, which offer higher yields than tax-exempts, at face value. In the case of Savannah, that would be about 14 percent below where the debt traded last week, data compiled by Bloomberg show.
“We didn’t want to be obligated to pay that higher interest rate and then have that subsidy not be there,” Richard Evans, Savannah’s chief financial officer, said of the decision to include the buyback clause. “We would want to let the dust settle on things and see how the market was dealing with it.”
Localities nationwide sold $188 billion of Build Americas before the program expired at the end of 2010. The issuers face potential subsidy cuts from automatic reductions in federal spending set to take effect in 2013. Payments to states and municipalities for the debt would drop by $255 million, or 7.6 percent, next year, the Office of Management and Budget said Sept. 14.
The office’s announcement laid out how more than 1,200 programs would be affected if Congress and the president can’t agree on a plan to shrink the U.S. deficit.
An impasse would force Obama to cut a combined $109 billion from next year’s budget. A bipartisan group of senators said this week they will work to craft a deficit-reduction plan intended to avert across-the-board cuts to defense and domestic programs set to start in January.
The risk that borrowers may buy back the debt, in some cases at a loss to debt-holders, may undermine support for reviving Build Americas and jeopardize a rally in the securities. The bonds are on a pace to beat Treasuries and tax- exempt munis for a third-straight year.
“It could be damaging,” said John Hallacy, New York-based head of muni research at Bank of America Merrill Lynch. “It could lead to some strong selling.”
Build Americas have returned 10.1 percent this year, compared with 6.4 percent for the broader $3.7 trillion muni market and 2.4 percent for Treasuries, Bank of America data show. They are little changed this month, while tax-exempts have earned 0.4 percent.
Some 2,275 Build America issues were sold, cutting borrowing costs by about $20 billion compared with tax-frees, according to the Treasury. The obligations pumped money into public works and made it easier for states and cities to borrow by drawing investors for whom traditional munis’ tax-exemption had no appeal.
About two-thirds of Build Americas have call provisions allowing local governments to buy back the securities, according to data compiled by Bloomberg.
Such provisions often allowed borrowers to repurchase the bonds at a price below so-called make-whole calls, under which investors receive a premium, in cases where the subsidy is cut, according to the National Association of Bond Lawyers.
Investors may sell bonds that can be called at face value if it becomes clearer that Congress will be unable to reach a deal, said Matthew Buscone, a muni bond manager in Boston with Breckinridge Capital Advisors, which oversees about $17 billion.
“There’s a pretty big risk, obviously, if you were planning on holding that coupon and enjoying that extra yield,” he said. “People might start selling just in the sense it’s a risk you can take off the table.”
In trading yesterday, the yield on 10-year AAA munis fell 0.02 percentage point to 1.74 percent. It dropped to 1.63 percent July 27, the lowest since at least January 2009, data compiled by Bloomberg show. Build America Bonds yield about 4.3 percent on average, or about 1.5 percentage points more than 30- year Treasuries, according to a Wells Fargo index.
When Columbus, Ohio, sold more than $190 million of Build America bonds in 2010 for projects such as roads and parks, it retained the option to buy back its debt at par should the federal payments be cut.
Megan Kilgore, assistant auditor for the city, said there is no immediate plan to do so. The city can bear the cost of subsidy losses announced by the Obama administration, she said. A 10-year Columbus bond traded for as much as $115 for $100 worth on Sept. 18, data compiled by Bloomberg show.
“We’re just going to wait it out,” she said. “At this point, I don’t have significant concern.”
Analysts at JPMorgan Chase & Co., Morgan Stanley and Citigroup Inc. said in reports that they see limited risk of a wave of refinancings.
JPMorgan analysts led by Peter DeGroot said in a report this month that Congress probably will reach a deal to avert the automatic budget cuts, given the risk to economic growth. Even so, the analysts said that based on Build Americas it reviewed, issuers would have to pay a premium that would make it costly to refinance, given current interest rates and how little of the subsidy they stand to lose initially.
Dan Close, who helps manage about $800 million of Build America bond funds in Chicago for Nuveen Investments, said the greatest consequence of a subsidy cut may be to sap interest in renewing the program. The Obama administration in February proposed reviving it at a lower subsidy rate. The recommendation didn’t advance in Congress.
“Even if this never does go through, it still has had the effect of really undermining the support that issuers might have in a program that might be revived down the line,” Close said.
The Bay Area Toll Authority, the agency financing construction of a bridge across San Francisco Bay, sold $3 billion of Build Americas to help pay for the span. Even if a subsidy cut has no impact on investors, there would be lingering concern that a cash-strapped federal government could shrink payments even more, said Brian Mayhew, Oakland-based chief financial officer of the authority.
“There’s no winning in this scenario,” he said. “The concept of the federal government reneging on a promise just leaves the question of when will they renege on the rest of it.”
Following are pending sales:
MINNESOTA OFFICE OF HIGHER EDUCATION is set to issue $375 million of revenue debt as soon as next week, according to the preliminary official statement. (Updated Sept. 28)
NORTH TEXAS TOLLWAY AUTHORITY plans to sell about $136 million in revenue bonds as soon as next week for refunding, according to an offering document. (Updated Sept. 28)
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