BABs Extension Will Aid the Tax-Free Bond Market February 1, 2010, John Mousseau, CFA, Vice President & Portfolio Manager
Bloomberg News reported yesterday that President Obama will ask Congress to make permanent the temporary Build America Bonds program (BABs) by which the Federal government subsidizes interest payments to state and local government issuers. We think this has a number of benefits for the tax-exempt municipal bond market and municipal bonds in general.
Under current law, the economic stimulus program from last spring provides a 35% federal subsidy or rebate on issuers’ interest costs for issuing bonds in the TAXABLE bond market. The current law extends this subsidy to the end of 2010. President Obama is proposing extending the BABs program permanently beyond 2010, but at a 28% subsidy level rather than the current 35%.
In the overall picture of municipal finance, we feel this is strongly positive for municipalities. At current longer-maturity BABs yields, the after-subsidy interest cost is still less than tax-exempt yields. This means lower interest costs for municipalities and certainly lowers the interest cost at the margin for new projects. This is the essence of the program and the reason for the stimulus effects.
The secondary effects, in our view, are also very positive for the tax-free bond market.
Continued use of the BABs market by municipal issuers is transforming TAX-free supply into TAXABLE BABs supply. By decreasing the amount of tax-exempt supply, it is forcing tax-free yields down – this was certainly true in the second and third quarters of last year, and we expect the extension of BABs will continue to force down tax-free yields.
The lower tax-free yields and the much better relationship to Treasuries should spur on advance refunding of older, higher-coupon bonds. You can see that the key relationship of 10-year tax-free yields (AA in this case) and 10-year Treasuries has returned to its historical norm.
The disjoining of the tax-free bond market and the US Treasury market which on the long-maturity end has been upside down for two years – is being spurred on by the BABs market to a more normal relationship. Many higher-coupon bonds issued from the fall of 2008 to the spring of 2009 are candidates to become prerefunded. Municipalities will clearly benefit from the present-value cost savings.
One question is what the effect will be on both the BABs market and the tax-free bond market by moving from a 35% subsidy to 28%. First and foremost, an issuer who can move up their financing plans from 2011 into 2010 will clearly do so. Let’s look at an example. Many high-grade issuers are enjoying BABs spreads over US Treasuries of approximately 180 basis points. This spread is down from last spring, when the initial spreads were 250-280. Of course, US Treasury yields in the long end have also risen, from 3.75% to the current 4.55%, which mutes some of the spread reduction. At a current 180-basis-point spread, this approximates a taxable yield of 6.35%. At a 35% subsidy rate this translates to an after-subsidy yield of 4.12%. This yield is much lower than all but the most gilt-edged issuers are enjoying. In fact, many high-grade tax-free yields are in the 4.5-4.75% range.
If we now employ a 28% subsidy instead of 35%, the after-subsidy cost of interest to the issuer rises to 4.57% – an increase of approximately 45 basis points. Clearly the DOWNWARD push effect of BABs yields on tax-exempt yields will be less at the reduced subsidy rate. This will mean MORE tax-exempt issuance, as the BREAKEVEN rate is higher; but on a LONG-TERM basis this should keep an upward ceiling on tax-exempt yields – remember, if tax-exempt yields rise too much, an issuer will look towards the BABs market – and that is the key to the extension of BABs: the natural “buffer” it puts into place against a rise in tax-free yields. If BABs issuance had been allowed to end at the end of this year, presumably we would have seen a marked rise in tax-exempt yields in advance of the removal of this financing device. The extension removes that scenario, in our view.
In summary, the extension of BABs, even at a smaller subsidy rate, should keep a lid on the rise in tax-exempt yields. The continuing use of BABs by issuers should be a positive force in grinding tax-exempt yields lower in the intermediate- and longer-term markets. This will benefit municipalities in two ways, through lower financing costs at the margin and the ability to advance refund older, higher-coupon bonds, thus lowering overall future interest costs. The smaller subsidy may cause some higher tax-exempt yields next year but, as we discussed, any rise in yields gets muted by the availability of the BABs market.
We will provide updates as this development takes shape.
Thanks to colleague Michael Comes for his research on this.
Cumberland AdvisorsSM is registered with the SEC under the Investment Advisors Act of 1940. All information contained herein is for informational purposes only and does not constitute a solicitation or offer to sell securities or investment advisory services. Such an offer can only be made in states and/or international jurisdictions where Cumberland Advisors is either registered or is a Notice Filer or where an exemption from such registration or filing is available. New accounts will not be accepted unless and until all local regulations have been satisfied. This presentation does not purport to be a complete description of our performance or investment services.
Please feel free to forward our commentaries (with proper attribution) to others who may be interested.
For a list of all equity recommendations for the past year, please contact Therese Pantalione at 856-692-6690,ext. 315. It is not our intention to state or imply in any manner that past results and profitability is an indication of future performance. All material presented is compiled from sources believed to be reliable. However, accuracy cannot be guaranteed.
Read Full Article »