Page 32 - May 23, 2024 Bulletin

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Rising BAB

Redemptions

Dana Sparkman, CFA
Senior Vice President/Municipal Analyst
Financial Strategies Group
The Baker Group

Build America Bonds (BABs) were created as part of the 2009 • Municipal-to-Treasury ratios, a common measure of relative value of
American Recovery and Reinvestment Act (ARRA). BABs are tax-exempt municipal bonds, for most terms have fallen significantly
federally taxable municipal bonds issued during 2009 and 2010 for with some nearing or reaching record lows. This has enabled some
which up to 35% of the borrowing costs are federally subsidized issuers to find savings by refinancing taxable BABs with tax-exempt
either through payments to the issuer (Direct-Pay BABs) or debt despite the interest rate hikes in recent years.
through payments to bondholders (Tax Credit BABs). The IRS • Further, issuers may want to reduce the risk of additional cuts in
estimates that more than $181 billion of BABs were issued by state the federal subsidy by refinancing BABs with tax-exempt debt. The
and local governments, and Bloomberg data suggests that about chart below shows the history of the subsidy cuts according to the
$116 billion of BABs were still outstanding as of March 2024. IRS:
Direct-Pay BABs often contain Extraordinary Redemption Provisions (ERPs),
which are usually triggered by a material adverse change in the subsidy. The
exact language varies amongst different bonds with some having precise
definitions of what constitutes a material adverse change while others contain
more vague verbiage. For the latter category, it has been widely viewed that
the federal subsidy cuts stemming from the Budget Control Act of 2011,
commonly known as sequestration, resulted in a material adverse change to the
subsidy and, therefore, triggered the ERP.
Extraordinary redemptions of BABs have occurred each year since
sequestration first started in 2013, but the amount called each year has
been rather low until recently. There has been a noticeable uptick in BAB
redemptions so far in 2024, and some analysts expect many more to be called
later this year. Investors may be puzzled as to why issuers are choosing to
redeem their BABs now if the ERP was triggered in 2013, and there are several The Municipal Securities Rulemaking Board (MSRB) noted in a recent brief
reasons contributing to this trend: that it has observed “a number of BABs trading in the secondary market
at a significant premium to par.” Spreads have widened somewhat as these
1. A court ruling clarifying that sequestration constituted an
“extraordinary event.” redemptions have become a more prominent issue, which indicates the market
may be starting to recognize an increase in the call risk present. However,
• A recent court decision (Indiana Municipal Power Agency v. US) investors who own or purchase BABs at a premium price may be at risk of
supports the conclusion that federal budget sequestration cuts did in realizing losses due to early redemption if the issuer chooses to exercise an
fact result in an extraordinary event that triggered many ERPs. This extraordinary redemption call option. Fortunately, today’s higher interest rate
decision provides the clarity some issuers needed to proceed with environment provides opportunities to favorably reinvest the redemption
redeeming their BABs using the ERP. proceeds, which is rather uncommon given that redemptions are usually more
frequent in falling rate scenarios.
2. Make-Whole call prices have fallen as market rates have increased.
These circumstances highlight the importance of investors researching and
• The price at which a bond may be redeemed is stated in the understanding all applicable redemption provisions, particularly when
prospectus for each bond. It can be at par, at a premium, or at a purchasing municipal bonds at prices above par. This information can be
make-whole call price. Make-Whole call prices provide investors found within the prospectus and should be provided on pre-purchase offering
with the net present value of the future principal and interest documentation as well.
payments, calculated using a specified benchmark rate plus a spread
as the discount rate. Make-Whole call options are rarely exercised Dana Sparkman, CFA, is Senior Vice President/Municipal Analyst
because they are usually very costly for the issuer, but higher interest in The Baker Group’s Financial Strategies Group. She manages a
rates result in a higher discount rate and a lower present value municipal credit database that covers more than 150,000 municipal
payment. Hence, a lower call price in current market conditions. bonds, providing clients with specific credit metrics essential in assessing
3. Market dynamics favor refinancing taxable debt with tax-exempt municipal credit. Dana earned a bachelor’s degree in finance from the
debt. University of Central Oklahoma as well as the Chartered Financial
Analyst designation. Contact: 405-415-7223, dana@GoBaker.com.

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