Muni bonds likely to suffer near-term price weakness as BABs expire

The potential expiration of the Build America Bond (BAB) program at the end of this year may have a negative near-term impact on the prices of the overall municipal bond market.

The BABs were not included in the tax cut extension agreement that President Obama recently negotiated with the Republicans, suggesting these securities might not be renewed next year.

“BABs were a win-win,” said James Colby, senior municipal strategist at Van Eck Global.

“The issuers were able to access capital markets very quickly and in large amounts, while investors received higher rates of returns and higher yields than those provided by conventional muni bonds.”

BABs were originally authorized under the American Recovery and Reinvestment Act that was signed into law in February 2009 -- and the first such products were issued in April of that year. These bonds were designed to help state and municipal governments gain rapid and easy access to capital markets (at a reduced cost) in order to finance infrastructure projects in their local regions during a time of severe credit constraints.

Like municipal bonds, BABs are issued by states, counties or municipalities (so they generally have very high credit quality). However, unlike the traditional muni bonds, the income generated by BABs are taxable.

In addition, BABs feature other attractive characteristics -- the issuer receives a subsidy from the federal government under which the state/municipal governments can issue bonds with competitive (i.e., high) interest rates relative to corporations. Through a tax break, the state/municipality would pay only a portion of the interest, with the federal government picking up the difference.

“What appeals to bondholders is their relative value -- spread to similar taxable, corporate and government bonds -- and the fact that this is a new asset class for taxable, institutional investors who have never used municipals before in their asset allocation,” Colby noted.

Needless to say, the BAB program was quite popular and successful -- leading to the issuance of more than $170-billion thus far. In fact, many BAB offerings were wildly over-subscribed.

Big institutional investors, including pension funds, which normally like to purchase sovereign bonds or corporate bonds, flocked to these BABs, as did many foreign investors largely because of their attractive rates (and spreads) and the diversification into a new asset class.

“The Republicans did not want to extend the BAB program because of the subsidy element,” said Colby.

“They viewed it as yet another form of stimulus. Given that the Federal Reserve just unveiled another massive round of quantitative easing, many in the government did not wish to have more stimuli.”

Muni bond prices, along with the prices of virtually all other domestic bonds, have already declined since earlier in the week when the tax cut extension agreement was announced.

Looking into next year, Colby believes that as BABs become unavailable, municipal governments will be forced to raising funds the old fashioned way – by issuing traditional tax-exempt muni bonds to fund their various projects. This will likely create a supply glut of these securities in the market, thereby hurting prices across the sector.