Build America Bonds Biggest Loser in Yield-Rise Bet

Thursday, 17 Oct 2013 11:38 AM

 

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The $188 billion market for Build America Bonds is set to trail the rest of municipal debt for the first time as issuers face cuts to their federal subsidies while investors bet interest rates will rise.

The taxable debt created under President Barack Obama’s 2009 stimulus plan has lost 6.1 percent this year, compared with a 3.7 percent drop for the $3.7 trillion municipal market, Bank of America Merrill Lynch data show. The bonds beat all local debt in the first three full years of their existence as they drew buyers from across the fixed-income universe.

Build America proceeds funded infrastructure projects, so the securities tend to have longer maturities. The duration has spurred sharper declines this year compared with other munis, said Dan Close at Nuveen Asset Management. Longer-dated yields have climbed since May on speculation a growing economy will lead the Federal Reserve to curb its bond buying.

“When they were issued, it made more sense for issuers to offer these as longer-dated obligations,” said Close. He runs the Build American Bond Fund and Build America Bond Opportunity Fund at Nuveen, which oversees $95 billion of local debt. “Underperformance against other fixed-income assets doesn’t have as much to do with spreads as their longer duration.”

Withdrawal Wave

Investors have yanked about $19 billion from long-term muni mutual funds this year, helping drive 30-year yields to levels unseen since 2011, and pushing them to a 20-month high relative to 10-year interest rates. The withdrawals are a reversal from 2012, when buyers seeking extra yield poured in $13 billion, Lipper US Fund Flows data show.

Bets that the Fed would taper its monthly debt purchases punished longer-maturity fixed-income obligations the most. The lengthiest muni maturities have lost 2.2 percent this year, while the shortest-dated have earned about 0.8 percent, Standard & Poor’s data show. The Wells Fargo Build America Bond index has an average maturity of about 26 years.

The bonds became the fastest-growing part of the muni market before the program expired at the end of 2010. Localities used the funds for infrastructure after the longest recession since the 1930s, receiving a 35 percent subsidy on interest costs from the federal government.

Yet states and cities now face higher interest payments on the debt amid budget battles in Washington.

Subsidy Slashed

The across-the-board federal spending cuts that began March 1, known as sequestration, cut the subsidy by 8.7 percent for states and cities. In 2014, the reimbursement will be curbed by 7.2 percent, the Internal Revenue Service said last month.

“Cutting the subsidy effectively reduces revenue of issuers of BABs,” a Moody’s Investors Service analyst, Nick Samuels, said in a report last week. While most localities plan to pay interest without the federal assistance, some “may need to make budget adjustments or draw on a debt service reserve to account for the reduced subsidy,” the report said.

Moody’s said the payment reductions were negative for Build America issuers that rely on the subsidy the most.

With a finite supply of the taxable debt, Build Americas gained 23 percent in 2011 and 12 percent in 2012, compared with returns of 11 percent and 7.3 percent for munis overall, Bank of America data show.

2013 Slump

This year, the bonds have slumped, even compared with other long-term debt.

The securities yield about 5.3 percent on average, according to the Wells Fargo index. The extra yield on the borrowings relative to similar-dated Treasurys rose to 1.6 percentage points on Sept. 24, the biggest gap in a year, according to data from Wells Fargo and Bloomberg.

Most analysts surveyed by Bloomberg predict long-term interest rates in the U.S. will rise in the next 12 months. Yields on 30-year Treasurys will jump to 4.26 percent in a year from 3.72 percent now, according to the median forecast of 44 analysts in the survey.

California borrowed the most through the program, followed by New York City and New York’s Metropolitan Transportation Authority, according to Moody’s.

The MTA, operator of New York City’s mass-transit system, will have to pay $7 million more annually in debt-service because of the curbed subsidy, said Aaron Donovan, an agency spokesman. It will continue to pay investors full interest, he said in an e-mail.

California’s Preference

California would “prefer that the federal government meet its obligations,” Tom Dresslar, a spokesman for state Treasurer Bill Lockyer, said via e-mail. “That said, the reduction in subsidies doesn’t exactly break the bank here.”

The loss represents a “minute” fraction of the state’s $98 billion general-fund budget, he said.

Most issuers can withstand the subsidy reductions and make interest payments even if the federal government halted reimbursements altogether, Close said. The program prohibited sales from issuers such as hospitals and retirement communities, which have historically been among the riskiest municipal borrowers.

“A subsidy reduction even for very large issuers under the program should not have a material impact on their ability to pay,” Close said.

Investors are still demanding higher interest rates to own Build Americas from issuers such as California.

Some state debt maturing in November 2040 traded Oct. 2 at a yield that was 1.96 percentage points more than Treasurys, the widest spread since June, data compiled by Bloomberg show.

Similarly, New York City Build Americas due in June 2035 traded Oct. 8 at a yield 3.42 percentage points more than benchmark Treasurys, the biggest penalty since July 26.

Issuance Increase

Issuers from Maine to California are set to offer about $5 billion in long-term debt this week, the most since the period through Sept. 27. They’re issuing with benchmark yields at the highest in three weeks.

The interest rate on AAA 10-year munis is 2.83 percent, the highest since Sept. 20, Bloomberg data show. That compares with 2.67 percent on similar-maturity Treasurys.

The ratio of the yields, a gauge of relative value, is about 106 percent, compared with an average of 94 percent since 2001. It has exceeded 100 percent since June 24. The higher the figure, the cheaper munis are compared with federal securities.

© Copyright 2014 Bloomberg News. All rights reserved.

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