In the grand scheme of things, they don’t cost federal taxpayers that much, so one would think that they stand a good chance of adoption, but nobody can take that for granted. It’s one of those esoteric topics that rarely makes the headlines outside of industry newsletters, but the benefit/cost ratio for local taxpayers is easily demonstrable. Whether the muni provisions make into law is now very much up in the air as the Senate whittles down its version’s “tax expenditures.”
Although many state and local officials are fixated foremost on the infrastructure bill, the House budget reconciliation bill has three provisions that are a big deal in the world of municipal bond finance; on the Senate side, these provisions are now in peril. One of them gives issuers of tax-exempt debt an option to sell their bonds on a taxable basis, pay a higher interest rate and receive a federal cash subsidy. Economists call it a “taxable bond option” (TBO), though it’s better known in the industry as Build America Bonds (BABs) from the Obama era when they were allowed temporarily during the Great Recession.
The idea is that because of the hefty income tax breaks that rich investors enjoy when they buy muni bonds, it ultimately costs Uncle Sam less to just let the issuers sell the bonds taxably and pay them a cash subsidy instead. Allowing a TBO/BAB is arguably more efficient because it opens the muni market to pension funds and foreign investors that have no need for federally tax-exempt income.
The only feature of the provision now pending in congressional committees that some might challenge is the rate of subsidy. The pending language would allow 35 percent, which is debatable. The interest-rate difference on taxable versus tax-exempt muni bond yields in the marketplace is not necessarily the same fraction as the top income tax rate for fat cats. Lots of lower-bracket investors buy muni bonds through mutual funds, and the TBO option would add demand from non-taxable investors, so an economist can prove mathematically that the subsidy rate should be somewhat lower unless the IRS’s highest individual income tax rate exceeds 40 percent (including the Obamacare Net Investment Income Tax).
Right now, the retail spread between taxable and tax-exempt muni bonds in the aftermarket is lower. So if advocates of the TBO/BAB provision need to offer up a concession to the congressional reconciliation committees, the best compromise would be a haircut on the cash subsidy. Alternatively, the subsidy could be lower (arguably an additional option, as little as 20 percent of total project costs) if paid upfront, which would actually reduce the volume of muni bond issuance and total interest costs all around. That would be my preference, although the congressional budget-scoring system won’t like it because the dirty little secret on Capitol Hill is that beyond 10 years, tax-exemption revenue leakage doesn’t count.
New Debt for Old Debt
Another provision under consideration is called “advance refunding.” Every homeowner who’s refinanced their mortgage in the past decade can understand this one, although it comes with a twist. Unlike a home mortgage that can be paid off at any time, municipal bonds are typically not “callable” for at least 10 years. Investors in municipal infrastructure bonds are unlikely to give a state or municipality the right to redeem their bonds any time rates go down; that would result in higher interest rates if it were the conventional expectation. For comparison, most U.S. Treasury bonds issued since 1985 are not callable because that “optionality” carries a price in the marketplace. Nonetheless, investors in the muni market have accepted the 10-year call feature as a standard convention for decades, and it persists today.
When interest rates decline, as they have over the past three decades, municipal bond issuers must generally wait until their old high-coupon bonds are callable and then issue new debt at the lower rate to replace those bonds. When that happens, the U.S. Treasury actually benefits because the interest rate on those new tax-exempt bonds will be lower and hence the tax loss from the exemption for fat cats will be less.
So it should come as no surprise that the investment bankers figured out long ago that to refinance old debt a muni bond issuer could sell new bonds at a lower rate and park the proceeds in an interest-earning escrow account to prepay the old debt when the prior bonds become callable. That trick is called advance refunding. The Treasury department generally dislikes this practice because it multiplies the amount of tax-exempt debt outstanding in the marketplace, hence driving up supply and the volume of tax avoidance. To make matters worse from the Treasury’s point of view, the municipality could invest in riskless Treasury bonds and actually make a profit during the escrow period, so Treasury began to require that the escrows be invested in special State and Local Government Securities (SLUGS, as they are known) that pay interest at a lower rate, which eliminates the interest arbitrage.
Historically, Congress had put limits on advance refundings, first allowing only two per project, then one, and then prohibiting them altogether in the 2017 tax law. Some would say that was a deliberate stick in the eye to state and local governments, especially blue states that issue lots of muni debt, all in the name of paying for the Trump tax cuts in the congressional scoring process.
The pending bill would reinstate advance refundings, and I say that’s great. Every issuer should be allowed one advance refunding, provided they follow the arbitrage restrictions on escrows until they call in the old bonds. Interest rates are at historical lows, and every dollar Uncle Sam might lose from this practice will be saved multifold by state and local taxpayers. Waiting to refund those old higher-coupon bonds when they are ordinarily callable will only invite higher interest costs to governments at all levels. This is not rocket science if you expect interest rates to increase in the coming years, as do I.
There’s a third provision that expands the annual per-issuer limit for muni bonds that banks can buy and claim income tax deductions. This one is a big deal for smaller communities and agencies, especially.
Lower Debt-Service Costs for Governments
Don’t kid yourself: The muni bond industry will love these arrangements if Congress adopts them in the pending bills. The backlog of old deals that can be advance-refunded at lower interest rates is like Glacial Lake Missoula in the Pleistocene age, waiting for the ice dam to break. Fortunately, the ensuing flood of refunding issues will be temporary and not devastating to the overall markets. The end result will be immediately lower debt-service costs for states and localities, and ultimately reduced tax-exempt revenue losses for the federal government.
The same is true of the BAB/TBO provision, as long as it’s calibrated correctly. We need more taxable muni bonds to be available to both public and private pension funds and IRAs. Foreign demand for taxable AAA or insured muni debt is healthy because American rates are higher than European and Japanese government bond yields.
The time is now. Before the ink is dry on pending drafts, state and local officials should be urging their representatives in both houses to endorse and save these cost-effective muni bond provisions.
Governing’s opinion columns reflect the views of their authors and not necessarily those of Governing’s editors or management.
