federal subsidy is distorting the market so that issuers are selling bonds at yields that are attractive to taxable buyers

TO BE NOTED: From Bloomberg:

"Taxpayers Lose $281 Million in Build America Bondholder Profits

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By Darrell Preston and Bryan Keogh

May 4 (Bloomberg) -- State and local public finance officials from New Jersey to California rewarded investors with $281 million of instant profits by selling debt through the government’s Build America bond program.

That’s how much prices of the five biggest bonds have risen in total since the first sales almost three weeks ago, according to Municipal Securities Rulemaking Board price data compiled by Bloomberg. About $7.6 billion of the debt, whose interest costs are partly subsidized by the U.S. government, has been issued.

Local officials say the federal subsidy has saved money compared with tax-exempt bonds. The rising prices of the securities and simultaneous decline in yields relative to benchmark rates shows municipalities would have saved another $1.32 billion in interest over the life of the bonds had they sold at current levels. The yields on $1.38 billion of debt sold by the New Jersey Turnpike Authority tumbled to 6.69 percent from 7.41 percent within a day of its April 20 offering.

“Some of these may have been good deals for the issuers, but could they have been even better?” said Ben Watkins, Florida’s director of bond sales. “They could have had much tighter pricing.”

New Jersey Turnpike spokesman Joseph Orlando declined to comment, referring questions to Dennis Enright, the authority’s financial adviser. Enright, president of NW Capital in Jersey City, New Jersey, called the sale “very successful.”

Buyers Rewarded

California’s $3 billion of Build America bonds sold April 20 and due in 2039 rose 2.3 percent, rewarding buyers with $68 million of profits and pushing yields down to 7.25 percent from 7.43 percent, Bloomberg data show. The state’s $2 billion of 25- year debt climbed 1.6 percent, or $32 million.

The New York Metropolitan Transportation Authority’s $750 million of debt, issued the same day, surged 6.8 percent, driving the yield down to 6.8 percent from 7.34 percent.

Build America bonds are part of President Barack Obama’s American Recovery and Reinvestment Act passed earlier this year to create jobs building roads, schools and infrastructure. The government pays a 35 percent subsidy on the interest rates that can cut coupons below those in the tax-exempt market.

The bonds are exempt from local taxes in the state of issue, though not from federal taxes. Strategists at Barclays Capital in New York predict the market may grow to as much as $150 billion over the next two years.

Relative Yields

Investors are snapping up Build America bonds because they offer the same yields as companies with lower ratings.

The New York Metropolitan Transportation Authority, ranked AA by Standard & Poor’s, paid 7.336 percent interest for its 30- year Build America bonds. At the same time, corporate bonds with the same maturity and rating yielded 6.10 percent to 6.19 percent, according to a Moody’s index. MTA bonds paid a yield higher than the 6.78 percent average for companies with A ratings from Moody’s, index data show.

The best opportunity for investors “is to get involved early” because “that’s where you’re going to get the cheap offerings,” said Scott Minerd, chief executive officer of New York-based Guggenheim Partners Asset Management Inc., which oversees about $30 billion. Minerd made the comments at the Milken Institute Global Conference in Beverly Hills, California, last week.

Municipal governments have been hit by the double whammy of rising borrowing costs and the recession since credit markets seized up in August 2007. Spending will likely exceed revenue in 34 states, the National Conference of State Legislatures said April 14.

Borrowing Costs

The cost of borrowing in the long-term tax-exempt municipal bond market has exceeded that of the U.S. government, with top- rated 30-year municipal bonds yielding 4.67 percent on April 30, compared with 4.09 percent for Treasuries of the same maturity. Muni rates have historically been less than Treasuries because of the tax exemption.

California’s bonds pay yields of 7.43 percent, the equivalent of about 4.83 percent after the 35 percent subsidy. Yields on California tax-exempt bonds were about 5.05 percent to 5.35 percent when the new securities were sold. Corporate bonds with similar ratings to California yielded 6.73 percent at the time, Moody’s data show.

“The federal subsidy is distorting the market so that issuers are selling bonds at yields that are attractive to taxable buyers,” said Evan Rourke, a money manager in New York for Eaton Vance Investment Co. “There was a certain amount of price discovery going on.”

Call Provisions

Savings on Build America bonds may be overstated because the securities include terms that make it unprofitable to refinance them if interest rates fall, limiting the municipality’s flexibility.

Muni bonds are typically sold with options that let borrowers buy back the securities after 10 years. The absence of a call option is worth 0.2 percentage point in yield to investors, according to San Francisco-based De La Rosa & Co., one of the underwriters on California’s bond sale.

Instead, most Build America bonds contain so-called make whole provisions, which require issuers to pay a premium to redeem the securities if interest rates decline. That would protect investors from borrowers paying off the bonds early and having to reinvest the proceeds in lower-yielding debt.

Florida Considers

Florida, which is considering Build America bonds, would have to make sure it gets a low enough rate to sacrifice the right to call the debt in 10 years, Watkins said. Investors “should pay up” for the assurance that they will be able to hold the securities for their full life, he said.

New York is evaluating whether giving up the option is worth the cost, Dominic Colafati, the chief budget examiner who oversees the state’s debt policies, said at a press conference in Albany. He declined to set a savings target the state would require to sell non-callable bonds.

“We are not 100 percent certain” it would be best for the state to give up the option, Colafati said. “We are trying to figure out based on real world experience what we can realistically expect.”

Local governments may not be gaining enough in lower yields for giving up the flexibility, said Andrew Kalotay, chief executive officer of Andrew Kalotay Associates Inc., a New York- based analyst of the value of fixed-rate bonds.

“They’re giving up a lot,” said Kalotay. “I’m not sure they’re getting such a good deal when they give up the call option.”

‘New Flavor’

Borrowers said they were told by their bankers that higher yields were needed to attract buyers to a new market, even though municipalities almost never default.

“We couldn’t sell them unless they were priced the way they were,” California Treasurer Bill Lockyer said in a phone interview. “This is a new flavor of bond.”

California saved between $1.2 billion to $1.7 billion compared with what it would have paid in the tax-exempt market and would have “lost millions of dollars in potential investors,” had it pressured buyers to accept lower yields, Lockyer said. Goldman Sachs Group Inc. and JPMorgan Chase & Co. underwrote the bonds. Spokesmen for the firms declined to comment on the pricing of the securities.

“It’s not like they make up a number, with a dartboard or something, to figure out what the yields should be,” he said. “They match the orders to see where they can make the sale.”

None of California’s underwriters held the bonds in their own account to profit from any potential increase in price in the following days, Lockyer said.

Muni Rally

Municipal bonds have rallied since the first sales of Build America debt, pushing yields on 30-year AAA tax-exempt securities down as much as 0.19 percentage point to a seven- month low of 5 percent, according to Municipal Market Advisors of Concord, Massachusetts. Tax-exempt sales fell about 29 percent to $25.5 billion last month from April 2008, according to Bloomberg data that doesn’t include variable-rate securities.

The New Jersey Turnpike Authority’s $1.38 billion of taxable 7.4 percent bonds due in 2040 gained 9.1 cents to 109.1 cents on the dollar, or $125 million, since the sale. Underwriters led by Morgan Stanley collected $12.7 million in fees.

Enright, the Turnpike’s advisor, called the sale “very successful” because the yield was within 4 percentage points of Treasuries with similar maturities. “Could it have been priced better?” he said. “You never know the answer to that.”

New Jersey general obligation bonds with 30-year maturities traded at yields of about 4.89 percent the week of the state’s Build America bond sale. The taxable securities had a yield of 7.41 percent, or 4.82 percent after the subsidy for an annual difference of 0.07 percent.

“Aggressively” Buying

New York’s Metropolitan Transportation Authority locked in “substantial savings,” said finance director Pat McCoy. The state’s rate on 30-year Build America bonds was 4.88 percent after the subsidy. That compares with an average interest rate of 5 percent on its tax-exempt bonds.

The price of the authority’s Build America bonds rose by 6.8 cents to 106.8 cents on the dollar.

“We understand that is a common dynamic in the taxable market,” McCoy said in an interview. “A couple of investors who received bonds in the allocation were eager to increase their position. They were aggressively going out and seeking to buy bonds.”

McCoy said “small-block trades” pushed up prices after the initial sale. The authority paid its underwriters a fee of about $8.91 per $1,000 of bonds, compared with $5.16 for the sale of tax-exempt debt the same day.

“This is a convention that we seem to be inheriting from the taxable market,” said McCoy.

Virginia Bonds

University of Virginia sold $250 million of 6.2 percent 30- year bonds on April 13. The securities climbed 7.6 cents to 107.3, or by $19.1 million.

Rated AAA by S&P, the school paid about the same yield relative to Treasuries as St. Louis-based Emerson Electric Co., which is ranked five levels lower and sold bonds the same week. Both were priced to yield 2.5 percentage points more than U.S. government debt. The school said it achieved about $2 million a year in interest savings by getting a yield lower than tax- exempt rates.

Yoke San Reynolds, the university’s chief financial officer, didn’t respond to a request for comment.

Some local officials said they haven’t figured out if Build America bonds provide enough savings.

“Among the things we are looking at is how they are priced,” said Nancy Kopp, Maryland’s treasurer, in an interview at the Milken Institute conference in Los Angeles. “My constitutional responsibility is to look out for the taxpayers of my state.”

To contact the reporters on this story: Darrell Preston in Dallas at dpreston@bloomberg.net; Bryan Keogh in New York at Bkeogh4@bloomberg.net"