March 26 (Bloomberg) -- The $188 billion Build America Bond market is extending a record rally as investors bet that municipal issuers repairing their finances can withstand reduced federal subsidies on the debt.
Under so-called sequestration that began March 1, $85 billion in federal spending cuts will be made for the fiscal year ending Sept. 30. That includes reducing the originally promised 35 percent subsidy on Build America Bonds to about 32 percent for U.S. states and cities from Hawaii to Maine.
Investors in the taxable securities remain undeterred, betting that improving revenue and a housing rebound will allow municipalities to shoulder the burden. The extra yield on the debt relative to U.S. Treasuries narrowed last week to 1.19 percentage points, the smallest since the program began in 2009, Wells Fargo & Co. data show.
“The fundamentals for munis continue to get better and the spread action on Build Americas is certainly reflecting that,” said Dan Close, who oversees $1.4 billion of the debt across six funds in Chicago for Nuveen Investments. “This is still a sector that can demonstrate spread compression.”
The bonds were created as part of President Barack Obama’s 2009 stimulus package, spurring localities to use the proceeds for infrastructure projects after the longest recession since the 1930s. It became the fastest-growing part of the $3.7 trillion muni market, with buyers attracted to the securities’ higher yields and issuers rushing to take advantage of the program before it expired at the end of 2010.
U.S. state tax collections have grown for 11 straight quarters, beginning in the first three months of 2010, according to a February report from the Nelson A. Rockefeller Institute of Government. The revenue has exceeded pre-recession levels since September 2011, according to the Albany, New York-based research group.
At the municipal level, purchases of new U.S. homes jumped in January by the most since 1993, Commerce Department figures show. Sales surged 15.6 percent to a 437,000 annual pace, the highest since July 2008. February data will be released today. Property taxes have made up at least two-thirds of total local-government revenue over the last 20 years, the institute said.
As states and cities have balanced their budgets, the U.S. government’s debt has swelled to more than $16 trillion. The Build America program’s 35 percent subsidy on interest cost the U.S. about $3.4 billion a year, and was among hundreds of areas to see reductions as a result of legislation passed in 2011 to shrink the federal deficit by $1.2 trillion over a decade.
“I had actually expected BABs would weaken early in March because people would focus on sequestration,” said Kathleen McNamara, a municipal strategist in New York at UBS Wealth Management, which oversees about $90 billion in local debt. “Enough investors felt that these issuers of BABs would be able to withstand the subsidy cut.”
Build America Bonds have returned 0.7 percent this year, outpacing the 0.4 percent gain for all munis and the 0.5 percent loss on Treasuries, Bank of America Merrill Lynch data show. The muni securities are on a pace for a record fifth-straight quarter of earning more than the broad market.
Even Build America Bonds from states most imperiled by federal cutbacks rallied this month. A Maryland security maturing in 2024 traded March 20 with the highest volume since September 2010, and at an average yield of 2.51 percent, the lowest ever, data compiled by Bloomberg show.
Maryland, which borders the nation’s capital, is one of four Aaa rated states Moody’s Investors Service has on negative outlook -- the same as the U.S. -- because they’re “highly dependent” on federal employment or transfer payments.
One exception to the rally has been Build America Bonds with features known as par call provisions. John Hallacy at Bank of America and Tom Weyl at Barclays Plc were among analysts who wrote reports warning a portion of Build America Bonds could be repurchased below market prices because of subsidy cuts.
Columbus, Ohio, the state capital, was one such issuer to sell debt with a par call provision. A bond maturing in 2023 traded March 14 at an average yield of 4.1 percent, up from 2.61 percent at the start of the year, Bloomberg data show. The price has dropped to about 106 cents on the dollar from 115 cents.
Obama last month called for new securities called America Fast Forward Bonds to boost state and local government spending on infrastructure projects. They would be similar to Build America debt.
After seeing promised grants cut back, states and cities will be less keen to use such a program, McNamara said. The scarce supply of Build Americas will only further enhance their appeal to investors, she said.
“When these bonds were first issued, it was probably the furthest thing from issuers’ minds that Congress would reduce the subsidy,” McNamara said. “The trust has been breached, but they continue to perform well.”
At 2.01 percent, yields on benchmark 10-year munis have exceeded the interest rate on comparable-maturity Treasuries for nine straight trading days, the longest span since October, Bloomberg data show. The ratio is about 105 percent, compared with an average of about 92 percent since 2001.
The elevated ratio may be attracting crossover buyers such as hedge funds, Nuveen’s Close said. The higher the percentage, the cheaper local bonds are relative to their federal counterparts.
States and cities are set to borrow just $3.5 billion this week, the least since the period through Jan. 4, Bloomberg data show. The smaller supply comes after the market set back-to-back records this year for issuance in the past two weeks.
Following are pending sales:
SAN BERNARDINO COMMUNITY COLLEGE DISTRICT in California is set to sell $280 million of tax-exempt and taxable bonds as soon as this week, Bloomberg data show. Proceeds will be used for refunding. Moody’s Investors Service rates the debt Aa2, third-highest. (Added March 26)
ILLINOIS plans to issue $800 million of general-obligation bonds via competitive sale April 2, Bloomberg data show. The state postponed a $500 million offer in January after S&P downgraded it to A-, six steps below AAA. Illinois is the company’s lowest-rated U.S. state. (Updated March 26)
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