Taxable Build America Bonds (BABs) extended a recent run of outperformance relative to both U.S. Treasury bonds and Corporate bonds despite an uncertain future. Last week, strong investor demand helped the market digest one of the heavier weeks of new BABs issuance witnessed this year. Municipalities that issued BABs took advantage of low interest rates and strong investor demand for yield to issue new bonds. In addition to yield, relatively attractive valuations also boosted investor demand despite the uncertainty. We believe BABs have proven successful enough in financial markets that they can continue to be used by income-seeking investors with or without new legislation to extend the BABs program.
In July, BABs underperformed their taxable counterparts as the initial attempt by Congress to extend the BABs program beyond its current year-end 2010 expiration failed. The uncertainty caused yield differentials, or spreads, between BABs and Treasuries and Corporate bonds to widen. In August, BABs new issuance was the lowest since July 2009, the third month of existence for the BABs program.
Attractive valuations coupled with lower supply helped create a favorable backdrop for investor acceptance of last week’s new issuance despite future uncertainty.
Recent demand underscores the value investors find in BABs.
As Treasury yields declined through August, BABs were a destination for income-seeking investors. The inherent credit quality of municipal bonds likely provided comfort to investors seeking another source of longer-term bonds besides Treasuries or Corporate bonds. According to Moody’s data, Investment-Grade rated Municipal bonds have had an average 10-year cumulative default rate of 0.06% versus 2.50% for Investment-Grade Corporate bonds from 1970 through the end of 2010. The substantially lower default rate speaks
to the strong credit quality of municipal bonds. In our view, since BABs can only be issued for qualifying infrastructure purposes, this provides an extra level of security for investors.
Foreign investors have been among the biggest buyers of BABs as they seek to diversify existing holdings of Treasuries and Corporate bonds. Last week, the Federal Reserve (Fed) reported that foreign holdings of BABs increased 15% during the second quarter of 2010 after increasing 19% during the first quarter. Fed data on weekly Treasury holdings of foreign central banks held in custody at the Federal Reserve Bank of New York show an increase in Treasury purchases in July and August likely in response to European debt concerns. Although third quarter 2010 holdings data will not be released for some time, we believe BABs, like Treasuries, likely benefited from foreign demand during the current quarter as well as from lingering European debt concerns.
Congress returned to session last week but an extension of the BABs program beyond its current year-end 2010 expiration remains elusive. Proposed legislation of the BABs program was initially included alongside Financial Reform legislation but was stripped out of the final version. The latest attempt to extend legislation was introduced in the House in late July but was postponed due to the summer recess. The legislation called for a two-year extension of the BABs program but with a lowering of the subsidy paid back to municipalities from its current 35% down to 32%, and then 30%, sequentially, over the two years. Last week, Chairman of the Senate Finance Committee, Max Baucus, appeared to reach a compromise by introducing legislation to extend the BABs program for one year at a 32%
Extension of the BABs program prior to the November election is unlikely in our view.
Congress will adjourn on October 8, 2010 for the mid-term elections, leaving only a few days on the legislative calendar. More prominent issues such as tax legislation will likely take center stage and political posturing ahead of the elections will likely limit progress on most legislation. Should the year end without an extension in place, legislation could still be enacted in 2011 but new legislation is harder to accomplish than an extension of existing legislation. The non-partisan Congressional Budget Office (CBO) recently raised the cost estimate of the BABs program by $10 billion over ten years to a total of $36 billion. While the dollar amount is only a drop in the bucket of the overall budget deficit, it is nonetheless being scrutinized given the smooth functioning of the traditional tax-exempt municipal market.
More from GFC, Below
Although considerable uncertainty remains, we believe a slightly greater probability exists in some form of extension occurring before year-end. BABs enjoy support not only from the Obama administration, but also from bond dealers and states have indicated strong support for an extension. The BABs program has proved an effective financing vehicle for municipal infrastructure projects.
Should the BABs program not get extended, BABs liquidity may be adversely affected. Bond dealers may choose to withdraw from participating in BABs trading without a steady flow of new issuance. A lack of liquidity could then lead to more volatile market swings. And BABs already possess above-average interest rate risk since over 90% of the sector consists of bonds maturing beyond ten years, according to Bond Buyer data. Failure to pass a BABs extension may put pressure on the prices of traditional tax-exempt long-term Municipal bonds, as BABs issuers turn back to the tax-exempt market for financing. Given the Fed data showing a shrinking market and still strong investor demand for tax-exempt bonds, we believe the expiration of the BABs program will pose little challenge to traditional taxfree
However, investors seeking diversification from Treasuries and Corporate bonds or investors simply looking for a high-quality income-seeking fixed income alternative may mitigate potential liquidity risk. Given our benign view of interest rates over the intermediate term, attractive valuations, diversification, and income benefits, we believe the benefits offset the risks of potential reduced liquidity. We believe BABs can still be used as an effective income vehicle with or without new legislation.
- The opinions voiced in this material are for general information only and are not intended to provide or be construed as providing specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and cannot be invested into directly.
- The market value of Corporate Bonds will fluctuate, and if the bond is sold prior to maturity, the investor’s yield may differ from the advertised yield.
- Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise, are subject to availability, and change in price.
- Government bonds and Treasury Bills are guaranteed by the U.S. government as to the timely payment of principal and interest and, if held to maturity, offer a fixed rate of return and fixed principal value. However, the value of a fund shares is not guaranteed and will fluctuate.
- High-Yield/Junk Bonds are not investment-grade securities, involve substantial risks, and generally should be part of the diversified portfolio of sophisticated investors.
- The issuance of Build America Bonds (BAB) began in April of 2009. They were authorized by the ARRA economic stimulus of 2009 and can be issued for qualifying infrastructure projects. They are taxable municipal bonds and are considered a category of bonds.