Build America Bonds look poised to extend their big 2009 run

Once you get past the uneasy concept of lending money to fiscally challenged state and local governments, there is plenty to like about Build America Bonds — and financial advisers should be taking notice.

First issued in April as part of the American Recovery and Reinvestment Act of 2009, the new category of taxable municipal bonds seems to have something for everyone, which is why it could be one of the biggest success stories in the controversial $787 billion stimulus package.

More than $64 billion worth of Build America Bonds were issued last year, beating initial forecasts for $50 billion in sales. Based on last year’s success, industry analysts expect BAB sales this year to more than double to $130 billion.

Considering the frantic pace and piecemeal objectives of the overall economic-stimulus effort, it would be difficult to imagine exactly what the designers of the muni Build America Bonds were hoping for. But what they got was a muni bond market attractive to a whole host of previously indifferent investors, including tax-exempt channels such has endowments, foundations, pension funds, foreign investors and even individual retirement accounts.

“From my perspective, this is the most important thing to happen in the fixed-income market in my entire 30-year career,” said Peter Coffin, president of Breckenridge Capital Advisors Inc.

Of the $11.5 billion worth of muni bond portfolios that Breckenridge manages, mostly for private clients, $500 million came in last year as BAB portfolios for small pension accounts and other tax-exempt institutions.

“It’s also a no-brainer to buy these [Build America Bonds] for individuals in a qualified retirement account,” Mr. Coffin said.

The basic BAB structure starts with an agreement by the federal government to subsidize 35% of the interest paid on a muni bond.

That federal support allows state and local government bond issuers — many of which are in desperate need of cash — to offer higher bond yields to investors.

In Massachusetts, for example, a 20-year tax-free muni bond that offers investors a 4.5% yield was transformed into a taxable BAB paying 6%. But thanks to the 35% federal subsidy, Massachusetts pays interest of just 4% on the issue.

The appeal from the bond issuer’s perspective boils down to simple math, which helps explain the white-hot popularity and growth potential of these muni bonds.

From investors’ perspective, the taxable municipals are competing with corporate bonds — and the clear advantage goes to the Build America Bonds with regard to both yields and default rates.

From 1970 to 2006, there were no defaults among triple-A-rated municipals, while corporate bonds defaulted at a rate of 0.5%, according to Moody’s Investors -Service.

Among single-A-rated bonds over the same period, the muni default rate at 0.03% was 40 times lower than the corporate-bond default rate of 1.3%.

With regard to yields, the 35% subsidy for the Build America Bonds places corporate bonds at a significant disadvantage.

A comparison of five-year bonds issued Dec. 16 and Jan. 7 shows corporate yields of between 20 and 77 basis points above that of Treasuries.

The comparable yields for the Build America Bonds were between 100 and 182 basis points over -Treasuries.

BEYOND YIELD

Of course, yield isn’t everything, warned Mohamed El-Erian, chief executive and co-chief investment officer of Pacific Investment Management Co. LLC.

“It is critical for investors to do detailed credit work, because issuers will likely face significant credit- quality head winds on account of declining revenue,” he said.

The ultimate upside of Build America Bonds — and the reason they are such a successful part of the stimulus package — is that their affect on the federal budget is likely to be negligible.

Although the 35% interest subsidy might sound expensive, it is actually just a twist on the subsidy that the federal government was already providing municipals by making them exempt from federal taxes.

It isn’t just a coincidence that the 35% subsidy is equal to the highest individual tax rate.

The biggest loser here is probably investors in traditional tax-free muni bonds.

“Every dollar’s worth of BABs that is issued is one less dollar of tax-free munis being issued,” Mr. Coffin said.

What’s more, as fewer tax-free municipals are issued, the resulting supply-and-demand imbalance drives down their yields.

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].

Related Topics: Investment Company Institute (ICI)