Build America Rally Waning as Subsidy Threatened: Muni Credit
Investors in the $188 billion market for Build America Bonds, which has outperformed all municipal debt the past three years, are at risk of getting caught up in federal spending cuts set to take effect March 1.
From Hawaii to Maine, localities sold the taxable securities before the program expired in 2010, benefiting from a federal subsidy on interest costs while luring global buyers to the $3.7 trillion muni market. If the Treasury Department trims payments amid federal cutbacks, some issuers can repurchase the bonds, in some cases at 10 percent or more below market prices.
The most vulnerable bonds are those that may be bought back at face value, according to Bank of America Merrill Lynch. Eaton Vance Management emptied its $100 million Build America fund of such debt in September. Buyers demand the most extra yield since June to hold that type of Build America Bonds, Bank of America data show.
“Issuers were quite aware and were always up front in saying we don’t 100 percent trust the federal government is going to do the right thing” as far as maintaining the subsidy, said Craig Brandon, a senior portfolio manager in Boston at Eaton Vance, which oversees about $29 billion of munis. “It was one of the risks that they looked at, and that we looked at.”
The program gives issuers a 35 percent subsidy on interest, costing the U.S. about $3.4 billion a year. It is among hundreds facing reductions as a result of legislation passed in 2011 to shrink the federal deficit by $1.2 trillion over a decade. In January, as cuts were set to take effect, Congress delayed them until March 1.
The bonds, created as part of President Barack Obama’s 2009 stimulus, became the fastest-growing part of the muni market. Localities used the proceeds for infrastructure projects. Buyers liked the securities’ higher yields. On average, the bonds yield about 1.2 percentage points more than benchmark Treasuries, according to Wells Fargo & Co. data.
Build America Bonds beat the broader muni market and Treasuries the past three years. The debt gained 11.5 percent in 2012, compared with 7.3 percent for all munis and 2.2 percent for Treasuries, Bank of America data show. In 2013, Build Americas are trailing the broader market. They have lost 0.3 percent, while all munis have earned 0.8 percent.
In September, Obama’s administration said the subsidies would drop by $255 million, or 7.6 percent, unless Congress agrees on a plan to avert the reductions.
Senate Majority Leader Harry Reid said this week that Democrats intend to advance a measure to avert the cuts through a package including steps to raise revenue. Senator Mitch McConnell, the Republican leader, said he doubted the cuts could be averted.
Build America borrowers routinely included clauses giving them the right to buy back the securities if the subsidy is cut. That would allow them to refinance the debt at lower interest rates, if doing so would save them money.
Often, the issuer has to pay a premium above Treasury yields, an option that may not be economical, according to John Hallacy, head of muni research at Bank of America in New York. However, in other cases localities can buy them for par, or $100 for $100 worth. Because of the rally in the bonds, the debt typically trades above par, putting investors at risk.
Investors have already marked down bonds in that category. Holders require 0.27 percentage point of extra yield to hold par-call Build America Bonds instead of debt with no call option, up from no gap in September, Bank of America data show.
One case is securities sold by Savannah, Georgia, for work on its water system. Bonds maturing in December 2018 traded for an average price of $112 on Jan. 9 to yield 2.19 percent, down from $115 in September, data compiled by Bloomberg show.
Similar bonds sold by Columbus, Ohio, that mature in June 2031 traded for an average price of $111 on Jan. 31 to yield 4.21 percent. That’s down from $117 in October.
Such securities are in the minority, said Michael Zezas, a muni strategist for Morgan Stanley in New York.
“It’s a risk, but we think it’s isolated to the par-call segment of the market, which we think should be relatively small,” he said.
Bank of America found that about 6 percent of bonds it reviewed had face-value calls that could hurt investors. More than 80 percent require borrowers to pay a specified interest rate above Treasuries, while about 12 percent had no call clause.
Cynthia Clemson, co-director of muni investments at Eaton Vance, said prices haven’t fallen enough to compensate for the risk on bonds that can be repurchased at face value.
“They’re not trading at low enough levels for us to be interested,” Clemson said.
Following is a pending sale:
NEW YORK CITY plans to borrow $1.4 billion of general- obligation bonds as soon as Feb. 25, according to the Office of Management and Budget. Proceeds will finance capital projects, refund debt and refinance variable-rate bonds into a fixed interest rate. (Added Feb. 14)
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