September began with “AAA” rated, 10-year non-taxable municipal bonds yielding 1.70%. 10-year bond yields spiked mid-month to 1.93% and ended the month and 3rd quarter yielding 1.70%. The supply of new issues slowed this past month relative to September 2011. Nonetheless, 2012 new issue supply through September ($250 billion +) has nearly eclipsed 2011 totals with a full quarter of issuance remaining. Annual issuance should exceed $350 billion this year.
Municipal bond demand weakened, but still robust
Demand for municipal bonds weakened a bit in September, but remains robust. As an example, California sold $1.75 billion of tax-exempt debt at an all-time low yield of 3.72% for its 30-year bonds. 10-year yields came in under 2.50%. Additionally, it increased the size of the offering to meet demand. Yields on the September issue were lower than what the state borrowed at in April of this year. Lastly, the yield penalty spread (versus 10-year, “AAA” rated yields) the state paid to borrow in September declined relative to April’s spread. All of this is good news for the Golden State and speaks to the continuing, generally strong demand for bonds from many different sectors of investors.
We were pleased to read State of California’s Controller John Chiang’s comments regarding the recent spate of Chapter 9 filings in the state. At a conference held in San Francisco, Controller Chiang opined the state needed to “participate in trying to prevent these bankruptcies.” Let’s hope other decision makers across the state feel similarly and take some needed actions in this area as we discussed in last month’s market update.
Sequestration revelation – BABs exposed
In September, what some suspected was confirmed. Build America Bonds (BABs), the darlings of the municipal bond world in 2009-2010, are not the panacea for the municipal bond market. BABs have lost some of their erstwhile luster and here’s why.
The last of the federally subsidized BABs were issued in December of 2010 with assurances from certain Treasury officials the federal subsidy to issuers would not be tampered with in future years. This was an important and needed assurance to both issuers and investors and was greatly responsible for spurring BAB issuance.
Any existing doubts about these Treasury assertions proved to be justified with the release this past month of an Office of Management and Budget (OMB) report. The report details (see page 157) the magnitude of BAB subsidy cuts if sequestration, as currently approved, occurs. If sequestration occurs, BAB issuers can expect an approximate 7.6% reduction in their promised federal subsidy.
Importantly, we note, issuers remain almost universally responsible for making 100% of BAB issue debt service payments. They will have to fund any federal funding shortfalls with other revenue sources if the federal government reneges on the promised subsidy. What does this mean for issuers and investors?
Subsidy cuts manageable for solid credits
If the BAB subsidy reductions occur, issuers will receive approximately 2.6% less of their total BAB interest costs. This is a manageable number for most issuers to absorb and they will have to cut costs elsewhere to make up for these subsidy shortfalls. BAB issuers with solid underlying credit quality metrics should not find this subsidy reduction problematical. As we have stated many times over many years, underlying credit quality matters and this situation serves to underscore that point.
Here are a few of the largest BAB issuers:
- State of California
- New York City
- New York City Water Authority
- State of Illinois
- New Jersey Turnpike Authority]
- MTA (New York)
- Bay Area Toll Authority (California)
Extraordinary redemption provisions may get triggered
BAB subsidy cuts may trigger extraordinary redemption provisions (ERPs). Each bond issue treats this potential situation differently. Certain BAB issues lack any ERPs. Certain BAB issues do have ERPs that are triggered at a penalty price to the issuer. Certain BAB issues with ERP features are callable at par with no penalty paid by the issuer. An examination of bond documents will clarify the specific provisions of any extraordinary redemption provisions.
Federal subsidy no longer untouchable
The reputational damage to the federally sponsored BAB and tax credit programs is immense. Despite repeated assurances from government officials to the contrary, it is now apparent the federal subsidy is not an untouchable budget item and cannot be automatically counted on by issuers and investors. The reality is it’s a line item in the federal budget subject to the whims of Washington politics and economic realities.
The OMB report clearly leaves issuers and investors with questions. Will the federal government honor its BAB subsidy commitment over the life of the bond issue or will future legislation render the commitments null and void? What is the upshot of the potential government’s changed BAB commitment beyond a reduced subsidy?
Elected and administrative officials of state and local governments across the country are urged to take the initiative and get themselves heard in front of lawmakers – underscoring the importance of protecting tax-exemption for public purpose essential governmental projects.
Certain proponents of the BAB program have advanced the notion it is the solution to solving the liquidity, inefficiency and inequality issues existing in the present day municipal bond market. Clearly it is not. This development demonstrates BABs are not a panacea for the present day market and the OMB report exposes why that is the case. If anything, the potential for federal backtracking on subsidy payments only serves to damage market liquidity and efficiency – two reasons BAB proponents give as strengths of the program.
Local governments need financially independent funding
As we stated in our white paper released last December, we do believe a modified BAB program has its place – but it IS NOT a substitute for the present day, sophisticated, well developed and competitive tax-exempt market place.
State and local governments need a financially independent funding source for their public purpose capital projects. The tax-exempt market provides them such a source. A federal-centric financing system will inevitably compromise the local decision making process and federal funding promises made today cannot be relied on by state and local governments.
This latest development with the four-year-old BAB program makes that point loud and clear.
Thank you for your continued confidence. Please call us with any questions or comments.
Ronald P. Bernardi
October 7, 2012