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the value, in billions, of taxable muni bonds sold this year |
Build America Bonds are here to stay as a new asset class in the muni bond sector, say market participants. The bond programme was introduced this year by the US government as a means of aiding states, local governments and non-profits in their fundraising because demand for traditional tax-exempt muni bonds had faltered. But interest in the Build America Bonds has been so high that investors and originators believe the taxable munis will emerge as a separate, high-grade asset class. The programme was introduced this year to last until 2010, and already $27 billion of the taxable bonds has been issued. Peter Coffin, president and founder of Breckinridge Capital Advisors, says that Build America Bonds are of increasing interest to institutional investors in both the US and overseas. His firm manages $10 billion in assets and specializes in customized municipal bond portfolios. So far the firm has around $500 million in Build America Bonds and that figure is increasing rapidly.
One reason for the success of the Build America Bond, believes Coffin, is that the traditional tax-exempt muni bond market lacks sufficient demand for long-term bonds. "Most muni bonds are long-term because the funds are used for long-term projects. Traditionally muni bonds have been bought predominantly by individual investors attracted to the tax-free yields but who tend to favour short-term or intermediate-term bonds. This creates a mismatch of supply and demand. To remedy this imbalance, long-term muni bonds up to 2009 were repackaged as floating-rate notes and purchased by money market funds. If a money market fund needed liquidity, they would simply sell them back to the bank or dealer who would then resell the bond at auction."
In the fourth quarter of 2008, however, there was an exodus from money market funds and the financial institutions were inundated with funds trying to sell back the notes. "The investment banks and dealers were so overwhelmed that they now want little to do with the product. Build America Bonds have changed the game and are attractive to a different set of investors so the financial intermediaries are welcoming them," says Coffin.
Higher yield
The Build America Bond Programme allows issuers to offer long-term bonds that are not tax-free. However, the US Treasury pays 35% of the interest cost. That has resulted in a higher yield and has therefore opened up the muni bond market to a wider range of investors.
| "State and local government debt is the one part of the economy that has not been overlevered. If they are under stress, they can raise taxes or cut spending" |
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Coffin explains: "Whereas with traditional muni bonds a 30-year bond might offer a 4.5% tax-free yield to the investor, now an issuer can offer a 30-year bond at a taxable 6% yield. A lot of investors, such as pension funds and endowments that might otherwise buy MBS or corporate bonds, are now looking at Build America Bonds as those markets have dried up and because of the similar yields." Spreads of Build America Bonds versus corporates look appealing. Stamford, Connecticut’s five-year Build America Bond was yielding 50 basis points over treasuries at the beginning of September, in line with Procter and Gamble’s five-year bond, and 30bp more than a Johnson & Johnson bond of the same tenor. In the 10-year maturity, Campbell, Kentucky’s Build America Bond yielded more than the 10-year bonds of both Hewlett-Packard and Shell. In the 30-year maturity, the New Jersey Turnpike Build America Bond yielded 175bp over treasuries, compared with Boeing’s spread of 140bp.
In addition, munis have a much lower default rate than higher-rated corporate bonds. Even in spite of fiscal pressures resulting from the recession, the creditworthiness of muni bonds is still strong. Coffin says: "State and local government debt is the one part of the economy that has not been overlevered. If they are under stress, they can raise taxes or cut spending, so are very resilient."
Bigger sizes
Randy Burleyson, director of municipals underwriting at BMO Capital, says that in addition to the relatively high yields, the size of the issues has attracted corporate investors. "There have been some large deals like the state of California’s $6.9 billion offering, so corporate bond investors have been able to buy $50 million-plus blocs," he says.
Jeff Bosland, head of muni bond business at JPMorgan, agrees. "The deal size and frequency of issue has created a liquid market – more so than for the traditional muni market. There are plenty more issuers to come, such as transportation, water and sewerage issuers. As more issuers become comfortable with the Build America Bond, we can only expect more issuance and greater liquidity."
Not that the Build America Bond is threatening the traditional muni market or the corporate debt market. Charlie Giffin, Build America Bond DCM specialist at JPMorgan, says that there is plenty of money looking to invest in debt. "Investors used to put 85% into equities. That is no longer the case, so they are looking for corporate debt still and other debt to invest in." Indeed, the traditional US high-grade muni market has seen yields fall as demand has picked up over the summer.
New model?
Given its success, it is likely that the Build America Bond programme will be extended beyond its 2010 end-date, market participants believe. However, the structure might have to be altered simply to make it more affordable for the Federal Reserve. Burleyson says: "There is speculation that the Build America programme will remain but the 35% cost paid by the Fed might have to be altered. It was initially expected that buyers would be US taxpayers so the cost paid by the Fed would be recouped in tax paid by the investor but many of the buyers have been mutual funds, overseas investors and corporations that do not pay at the 35% rate. The government might end up clawing back much less than projected, so the model is likely to have to change."
