Tracking the Recession: Investors Buying Up New State-Issued Bonds

State finance officials are uttering a new acronym in this year of TARP (Troubled Asset Relief Program) and ARRA(American Recovery and Reinvestment Act). It’s BAB, short for Build America Bonds, or taxable municipal debt issued by state and local governments that is partially subsidized by the federal government.

The two-month-old program, part of the billion federal economic stimulus plan, is catching on among financially distressed state and local governments looking for cash through the credit market. Borrowing costs are lower because Uncle Sam refunds 35 percent of the interest charges.

The bond money finances work on public buildings, ranging from schools to hospitals to water treatment plants to government housing to roads and bridges.

Between the first public sale April 15 and May 20, U.S. Treasury officials say about .5 billion of Build America Bonds have been sold, as orders initially exceeded the supply. By the time the program closes at the end of next year, officials say the total could reach billion and create thousands of jobs.

“The Build America Bond program has just begun, ” Alan Krueger, assistant Treasury secretary for economic policy, told a House subcommittee on May 21. “While it is premature to make any general statements about the program or its future prospects, the early signs are positive.”

On separate days in a single week in April, the state of California, the New Jersey Turnpike Authority and the Metropolitan Transportation Authority of New York experienced such strong demand from investors that each boosted the size of their sale.

California upped its planned billion offering to .85 billion, most of which was BABs. The money could create as many as 90,000 jobs, officials said. The transportation authority, which operates New York’s subway system, issued million, which was million more than first proposed.

Ohio (.8 million) and Louisiana ( million) were the most recent state governments to join the BAB surge.The bonds also are popular with some state schools; the universities of Virginia and Minnesota were the first to issue the debt to pay for a variety of campus projects.

“The program’s popularity and growth over the last two months are clear indications it is delivering the kind of assistance to state and local governments that Congress intended when it created the program,” said Michael Decker, co-chief executive officer of the Regional Bond Dealers Association in Washington, D.C.

Usually states sell tax-exempt municipal bonds to raise capital for building projects, but the recession has limited their access to borrowing. Congress and the Obama administration designed the BAB program as a temporary way for governments to issue taxable debt for those projects, which usually qualify for tax-exempt financing. States can sign up for the subsidies through the end of next year, although the federal assistance is paid over the full term of the bonds.

The interest rates are higher on taxable bonds but the federal government lowers the rate for states through its rebate. These reductions will likely mean savings of billions of dollars in interest costs over the next 30 years, officials say.

When California sold its bonds in April, the net interest rate with the federal subsidy was 4.83 percent, which compares to interest costs of as much as 6.10 percent the state paid on tax-exempt general obligation bonds it sold in March. The lower yields will save .68 billion over 30 years, state officials said.

BAB buyers differ from the traditional tax-exempt bond market, which includes more than 50,000 state and local government issuers, up to 15,000 sales a year averaging about million and individual, small investors. BABs are attracting big institutional investors who usually would not buy municipal bonds because they cannot take advantage of tax-exempt interest, Decker said. These investors include pension funds, university endowments, foreign investors, life insurance companies, 401k retirement accounts and others.

Despite states’ initial burst of enthusiasm over having an additional financing source, the BAB program has its challenges. Krueger said the Treasury department will have to develop a capable electronic system to funnel the subsidy payments to state and local governments. The IRS will need to develop tax compliance measures because the subsidies are similar to tax refunds, Krueger said.

State and local governments could also find selling taxable bonds more confining than issuing tax-exempt debt, Decker said. Taxable bond investors prefer paying the loan amount when it matures, earning interest until then. Tax-exempt municipal bond buyers pay principal and interest over the term of the loan, making level payments much as a mortgage loan. It also may be necessary as a condition of the sale for BAB issuers to forego the ability to redeem bonds early in order to refinance at lower interest rates.

Decker said another concern is that the federal government could scale back or eliminate the subsidies in the future. Some of the bonds have been issued with extraordinary provisions that allow state and local governments to “call” the bonds back and refinance them if the federal government stops paying the subsidy on the interest.