Bloomberg News

Build America Suffering Most as Sequestration Bites: Muni Credit

August 14, 2013

Build America Suffering Most as Sequestration Bites

California Build America bonds maturing April 2039 and rated four steps below benchmark munis by Moody’s Investors Service traded Aug. 12 with an average yield of about 5.2 percent, Bloomberg data show. Photographer: Ken James/Bloomberg

Build America Bonds, the federally subsidized municipal bonds orphaned in 2010 after Congress failed to extend their life, are beating Treasuries and corporate debt even as the taxable securities are poised to record their first losing year.

With $188 billion outstanding, Build America bonds helped finance a bridge spanning San Francisco Bay and dormitories at Rutgers University in New Jersey. They’ve declined 5.4 percent in 2013 through Aug. 12 after gaining every year since April 2009, when sales began, Bank of America Merrill Lynch data show. The debt is set to post a negative annual return after investors pulled the most cash from muni mutual funds since 2011 on speculation that the Federal Reserve would reduce bond purchases, said Justin Hoogendoorn, a managing director at BMO Capital Markets in Chicago.

Federal spending cuts resulting from budget sequestration are also feeding the losses, Hoogendoorn said. Since March 1, states and cities have received 8.7 percent less toward interest costs from the U.S., prompting some issuers to redeem securities before they mature.

“You had both people getting out of bonds and people trying to be a little more judicious on BABs.” Hoogendoorn said. “It’s just a recipe” for negative performance.

Widest Penalty

This would be the first time since 2009 that the taxable securities earn less than the broader $3.7 trillion municipal-bond market. Compared with 30-year U.S. Treasuries, investors are demanding close to the widest yield penalty in 11 months to buy Build America bonds maturing in 26 years, data compiled by Bloomberg show.

Interest rates on local securities climbed to the highest levels in more than two years as investors withdrew $14.8 billion from U.S. muni mutual funds in the eight weeks through Aug. 7, the most since February 2011, Lipper US Fund Flows data show.

“Sellers build up, you don’t have buyers, inventories tend to grow, dealers are losing money and they’re forced to get their positions down, Hoogendoorn said. ‘‘Consequently, it just becomes a rough time.”

The extra yield that investors demand to buy Build Americas maturing in 26 years rather than 30-year federal debt was 1.53 percentage points July 25, the widest spread since September, data compiled by Bloomberg show. The yield difference was 1.44 percentage points Aug. 12.

Obama Stimulus

Created under President Barack Obama’s 2009 economic stimulus, Build America bonds gave state and local borrowers a 35 percent federal subsidy on interest. Congress refused to extend the program after 2010. Then came sequestration, after the lawmakers mandated $1.2 trillion in across-the-board spending cuts, to begin in 2013 and be spread over nine years, as part of a 2011 deal to increase the U.S. debt limit.

U.S. spending cuts of $80.1 billion that started March 1 because of sequestration include reducing subsidy payments for Build America securities by 8.7 percent, according to the Internal Revenue Service.

Since the subsidy cuts began, Columbus, Ohio’s capital city, as well as localities in Illinois, Wisconsin and Minnesota have purchased or plan to buy back some Build America bonds from investors at 100 percent of principal, plus accrued interest.

‘Negative Taste’

The move to reduce federal support “leaves a negative taste” for investors, said Paul Mansour, head of muni research at Hartford, Connecticut-based Conning, which oversees about $9 billion of munis, including about $1 billion of Build America debt.

While the bonds are poised to lose value in 2013, their relative appeal against Treasuries and company debt make them a good alternative for investors, Hoogendoorn said.

“The fact that the spreads have widened out more recently -- that often creates a better landscape for the product to tighten going forward,” Hoogendoorn said.

Build America bonds’ 5.4 percent loss this year is less than half the nearly 11 percent drop in value for federal debt with an average maturity of 27 years, Bank of America Merrill Lynch data show. Corporate securities with an average rating three steps below benchmark obligations and an average maturity of 26 years have lost almost 8 percent in 2013.

Higher Income

“For long-duration accounts, Build America Bonds are still very valuable and provide a good substitute for corporate bonds,” Mansour said. “And for corporate bonds of similar ratings, they generally produce higher income.”

California Build America bonds maturing April 2039 and rated four steps below benchmark munis by Moody’s Investors Service traded Aug. 12 with an average yield of about 5.2 percent, Bloomberg data show. That compares with a yield of 4.6 percent that Commonwealth Edison Co., a provider of electricity in Chicago and northern Illinois, received when it sold on the same day debt maturing August 2043 and rated two levels below the California Build Americas.

Build America borrowers “tend to be very high quality, large issuers so they have good liquidity,” said Cynthia Clemson, co-director of muni investments at Eaton Vance, which oversees $13.4 billion of munis, including $89.1 million of Build America obligations. “If you can get a little extra yield versus some other opportunities, they may make some sense in people’s portfolios.”

Default Risk

Municipalities default less frequently than corporate borrowers, according to a Moody’s Investors Service assessment of issuers it rates. From 1970 to 2012, an average of 5.7 percent of munis that were sold a decade or more earlier and had a junk rating defaulted, compared with 33.9 percent for company debt.

At 4.6 percent, benchmark 30-year munis are at their highest level since April 2011, Bloomberg data show. That compares with 3.76 percent for federal debt with similar maturity.

The ratio of the two yields, which shows relative value, is about 122 percent, compared with a five-year average of 112 percent, Bloomberg data show. The higher the ratio, the cheaper munis are compared with Treasuries.

Following are pending sales:

California plans to start selling about $5.5 billion in short-term revenue-anticipation notes today to individual investors in $5,000 minimum amounts. The securities will mature during the current fiscal year, which ends in June 2014, and will produce funds to help the state manage its cash flow. The offering will conclude tomorrow with institutional orders. The tax-exempt notes are graded MIG1 by Moody’s Investors Service, SP-1+ by Standard & Poor’s and F1 by Fitch Ratings, its second-highest level. Units of JPMorgan Chase & Co. (JPM:US) and Morgan Stanley (MS:US) are managing the sale.

The New York State Dormitory Authority plans to sell about $526.7 million in revenue bonds as early as next week. The proceeds will be used to fund construction and to retire lease-revenue debt. The securities are backed by money received for use of dorms on 26 of 29 state university and college campuses, serving about 70,000 of the system’s 218,000 students each year. The bonds carry maturities through July 1, 2032. Bank of America Corp. (BAC:US)’s Merrill Lynch unit is managing the offering.

To contact the reporter on this story: Michelle Kaske in New York at mkaske@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net


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