Why is this good fortune springing from the slough of despond? The decline in the yields on U.S. Treasury securities, which form a foundation of fixed-income investments, has helped. But the most important factor was one that this column focused on last July: the huge and growing impact of Build America Bonds, known as BABs. These investment vehicles, which were created under the banner of the American Recovery and Reinvestment Act, are the muni-market equivalent of Cash for Clunkers.
A BAB is a taxable bond. It can be issued for a variety of public purposes and carries a 35 percent federal subsidy that is subtracted from the interest rate paid by the issuers. BABs have surged in popularity: Some $32 billion in these securities were issued during the five months after BABs first went on the market, at the beginning of April. About 17 percent of the total municipal bond volume so far this year has gone out on a taxable basis. This blossoming of the subsidized taxable bond has siphoned off much of the supply of bonds from the tax-exempt precincts of the market. The smaller supply of tax-exempt securities has meant that interest rates on those bonds have fallen sharply.
The taxable bonds appeal to a very different set of investors than do the traditional tax-exempt bonds. They attract long-term investors such as pension systems and other large public bond funds. The enthusiasm of these buyers for the long maturities of the taxable bonds has had a major impact on the average maturity of all new municipal bonds. The savings for borrowers are such that they are issuing these bonds in the longest maturities. That's where their advantage over conventional tax-exempts is the greatest. This often means "split" issues, with the short-term bonds sold on a tax-exempt basis while the long maturities are sold as BABs. The overall consequence is that issuers are stretching their debt out further and further.
Meanwhile, short-term yields are very, very low in the tax-exempt money market funds. As a result, investors have moved out along the yield curve, buying longer-term obligations that provide higher returns. Also, since ARRA increased the issuance limits on bank-qualified bonds--from $10 million to $30 million--sales of these small-issuer bonds have almost doubled in volume when compared with last year.
While the overall tax-exempt bond market seems to be doing surprisingly well given the limping state of the economy, there are some soft spots. One is in the area of so-called "dirt bonds." These bonds are issued by special districts that are set up by developers to pay for the infrastructure of new residential and commercial developments. The housing boom of the mid-2000s saw a surge in such real-estate related bonds. Once the boom backfired, these bonds did, too. For example, some 600 Florida districts issued around $6.5 billion in dirt bonds, about one-half of which are now in default. But these defaults have been rather curious. Bond funds are buying the defaulted bonds at deep discounts. The funds pay the special district tax payments (which means they are paying themselves for the interest payments). What they are buying, in effect, is control of properties at pennies on the dollar. The idea is that they can work with developers to revive projects in better times. Hope springs eternal.
