A little more than a week after they were first issued, sales of Build America Bonds have reached nearly $10 billion and are climbing. Some estimates anticipate that sales of the federally subsidized taxable municipal bonds could reach $50 billion annually during the two years in which states, municipalities, and government entities are allowed to sell them.
At the current pace, these bonds will start showing up everywhere.
The early momentum is helped along by a kind of bandwagon mentality that tilts strongly in favor of this latest manifestation of the $787 billion economic stimulus plan. And, of course, the initial appeal of the bonds is as conspicuous as the name.
Issuers get to collect a 35% annual rebate from the federal government on the interest paid on the bonds. That rebate allows various government entities — including university systems in Minnesota and Virginia, the New Jersey Turnpike Authority and the state of California — to offer more attractive yields.
For example, the $5 billion worth of Build America Bonds issued last week by California at a 7% yield will only cost the state 4.5%. Not too shabby a way to funnel money into the budget, especially to finance a state on the brink of bankruptcy.
Then there is the taxable status of the bonds, which differs from traditionally tax-exempt muni bonds. This isn't an insignificant aspect of Build America Bonds, according to Josh Gonze, who manages $3.5 billion in six muni bond funds for Thornburg Investment Management Inc. of Santa Fe, N.M.
"A lot of investors [such as pension funds] don't pay taxes, so they don't normally want tax-exempt bonds," he said. "But at the same time, these investors might want some di-versification beyond corporate bonds or mortgage-backed securities."
In theory, the pension funds, foundations and endowments that have traditionally ignored the muni bond market will now have a reason to take a closer look. Thus, as the Build American Bond market chases the new big-money target, and as the new big money becomes receptive to the bonds, the old-fashioned $2.7 trillion tax-exempt muni bond market gets a boost of its own.
"Every time a BAB gets issued there's a tax-exempt bond that doesn't get issued," Mr. Gonze said. "That drives down yields and drives up prices on tax-exempt bonds."
Of course, that theory is partially based on the premise that the demand for capital among the nation's various municipalities will remain stagnant. This is where the ride on the Build America Bonds bandwagon could get a little dicey.
The three main revenue sources for most states and municipalities are taxes on sales, income and properties — collections of which are declining amid the economic downturn. As revenue moves south and access to debt becomes more readily available, it seems only logical that, even with the federal subsidy, the Build America Bonds only inflate municipal debt and put off the inevitable.
"It's a pretty good return, but it's too risky for me," said Bert Whitehead, president of Cambridge Connection Inc. in Franklin, Mich. Mr. Whitehead, who advises clients on a flat-fee and retainer basis, called them "little more than junk bonds."
"It seems that the more municipalities do this, the riskier it gets," he said.
As the Build America Bond strategy continues to spread, it will be interesting to see whether smaller municipalities participate and if there is enough appetite for the bonds among the new breed of non-traditional muni bond investors.
As a strict tax-exempt bond investor, Mr. Gonze is restricted by way of prospectus from investing in the bonds, but that hasn't dampened his enthusiasm. "I think they're fine," he said, shooting down the notion of municipalities chasing the bonds into a black hole of unmanageable debt.
"Despite all the credit crisis headlines, most states and municipalities are not having trouble raising money," Mr. Gonze said. "States and municipalities will experience declining sources of revenue in 2009, but that doesn't translate to downgrades and defaults."
Mr. Gonze added that most states are required to balance their budgets and that debt is often prioritized second behind education spending.
Unfortunately, it is still too early to know where that 35% subsidy might ultimately rank in the federal budget.
A new Investment Insights column appears every Monday on InvestmentNews.com. E-mail Jeff Benjamin at [email protected].
