The U.S. economy, mired in the worst recession in decades, has caused unprecedented fiscal challenges for many municipalities grappling with declining revenues (e.g. income, sales and property tax receipts) and higher borrowing costs.

However, in recent months, conditions in the tax-exempt municipal bond market have improved for both issuers and investors, in part due to a stimulus lifeline sent by the U.S. government earlier this year in the form of Build America Bonds.

BABs provide muni issuers with source of cheaper capital
Build America Bonds (BABs) are a new type of debt instrument that offer municipalities a 35% federal subsidy on interest payments when they borrow capital by issuing taxable bonds.i These bonds were authorized as part of the $787 billion federal stimulus legislation passed earlier in 2009.

One of the first of many public borrowers that recently took advantage of the new Build America Bond program was the state of California, which possesses the lowest credit rating of any state in the nation and lacked easy access to the capital markets in 2008 due to the nationwide credit crunch. Facing fiscal pressures and a massive budget stalemate, California issued nearly $5.2 billion of taxable, long-dated BABs in April as part of the new program—the biggest offering in the state’s history.

Thanks to Uncle Sam’s fiscal generosity, the Golden State issued its taxable BABs at higher prevailing rates than bonds offered by many other comparablyrated corporations, but paid a lower actual rate of interest (borrowing cost) because the federal government picked up 35% of the tab.

What’s more, at the time of California’s issue, the state’s true borrowing cost (net interest rate) on these bonds was between 80-100 basis points (or roughly 1 percentage point) less than what it would have had to pay by issuing bonds in the traditional tax-exempt bond market. The lower rate offered on California’s $5.3 billion issue of BABs is estimated to save the state more than $1 billion over the life of the bonds, which were issued at 25- and 30-year maturities.

For California and other municipal issuers that have since taken advantage of the new program, the ability to raise capital through the issuance of taxable bonds and obtain a federal subsidy on the cost of borrowing that capital has meant billions in savings. Further, having the ability to sell taxable BABs has allowed some municipal issuers to refinance maturing debt at lower costs, which in effect has reduced their debt service and helped improve their perceived creditworthiness.

Read Full: Build America Bonds Ease Stress in Muni Bond Market

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Market Analysis, Research & Education
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KEY TAKEAWAY
The recent popularity of taxable • Build America Bonds (BAB) has allowed budgetary-pressured municipal issuers to raise new capital and refinance maturing debt at lower borrowing costs, improving their overall creditworthiness.

The municipal issuance of these new taxable bonds also has helped stabilize difficult credit conditions and boost performance for investors in the tax-exempt municipal bond market.

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