The municipal bond market is likely to be even more confounding over the next few weeks as investors, and state and local borrowers, continue to rush to take advantage of the Build America Bond program, which is set to expire at the end of the year.
Instead of bolting for the exits, however, investors might be better off just buckling in for a near-term bumpy ride.
The popular federal subsidy program, which was enacted in 2009 as part of the American Recovery and Reinvestment Act and helped dozens of municipalities issue more than $170 billion in taxable bonds, was designed to stimulate demand for muni bonds among pension funds and other institutional investors. Typically, such investors avoid muni debt — which is normally tax-exempt — because they already pay no federal income taxes.
The BAB program works by encouraging state and local issuers to issue taxable debt by offering them a 35% federal subsidy intended to offset the higher interest rates they otherwise would pay.
While the program's expiration is imminent, the White House and key Democrats have been pushing to keep it going for at least another year or even make it permanent.
Their efforts, however, appear to be failing. Last week, the Senate blocked a proposal to extend the BAB program from being attached to draft legislation that would extend Bush-era tax cuts.
FLOOD OF ISSUANCE
The prospect of the program's demise has led to a flood of BABs issuance over the past few months as municipalities scramble to get in under the wire.
Of the $110 billion worth of BABs issued year-to-date through Nov. 26, $26 billion was issued in the eight-week period after Sept. 30.
“Given the increased issuance, this could create a short-term opportunity in BABs because by flooding the market with supply, it has pushed up yields,” said Christian Hviid, chief market strategist at Genworth Financial Asset Management.
Meanwhile, for traditional retail investors of tax-exempt muni bonds, the BABs turmoil is just adding to the confusion.
One theory is that if the BABs program goes away, the traditional muni bond market would be flooded with new issuance, driving up yields and driving down values of existing bonds.
Such a scenario doesn't sit well with investors already overwhelmed with fiscal horror stories from state and local governments.
“The number of fundamental issues, combined with increased supply, could be a one-two punch for [traditional] munis right at a time when investors are more reluctant to buy them,” said Andy Kapyrin, portfolio analyst at RegentAtlantic Capital LLC.
The combination of fundamental and technical challenges, he added, could lead to a “rough time for munis over the next few months.”
While near-term volatility, triggered by nervous investors, is very likely, the long-term muni outlook actually may be brighter than the current gloom suggests.
First, while the air is full of talk of municipal bankruptcy, default rates are still well below 1%. Moreover, there are safeguards in place that make honoring debt one of the highest priorities in most jurisdictions.
“Everything we're hearing about budget problems has everyone worried about where the next shoe will drop, but even in a state like California, where there are clearly budget issues, the muni bonds have to be paid right after education is funded,” said Eric Jacobson, an analyst with Morningstar Inc.
Second, the so-called institutional smart money has been buying up BABs over the past two years, representing 21% of all muni bond issuance.
Finally, one contributor to the current negativity and a positive sign for the future is today's supply-and-demand situation.
Some muni experts contend that the heavy BABs issuance over the past few months actually represented debt that might have otherwise been issued next year.
Thus, even if the BABs program is extended, total muni bond issuance is likely to be lower, not higher, next year, which could support higher bond prices.
And regardless of whether the program is extended, municipalities in this climate can justify paying only so much interest on debt to finance infrastructure projects, according to Matt Fabian, managing director at Municipal Market Advisors, an independent research and strategy firm.
“When the rates rise, the issuers will sell less debt, because it means the cost of those projects go up,” he said.
Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected].
