Outlook 2011: BABs define 2010; fewer refinancings, no BABs could mean lower issuance in 2011

By Sheri Kasprzak

New York, Dec. 31 - The year in municipals was defined by a three-letter abbreviation: BAB. As the year drew to a close, however, the existence of Build America Bonds beyond 2010 became more and more unlikely, making predictions about municipal issuance in the coming year cloudy. The BABs program expired Dec. 31.

The Securities Industry and Financial Markets Association reported late in December that a survey of municipal market insiders indicated that expected total municipal issuance in 2011, including taxable and tax-exempt debt, could reach almost $500 billion, up slightly from the survey participants' expectation of $492 billion for 2010. One market insider noted that issuance for 2010 was poised to clear $430 billion, a record set in 2007, but exact figures were not immediately available.

The expectations for 2011 might be rosier than reality, according to George Friedlander, senior municipal bond strategist for Citigroup Global Markets Inc. In late December, Friedlander said that an anticipated drop in advance refundings could mean a substantial decline in muni issuance. Friedlander and his analysts predicted in a report released in December that municipal issuance in 2011 could total just $340 billion.

Friedlander said in the report that the refinancings are likely to decline in 2011 because dropping yields encouraged so many municipalities and other issuers to refinance in 2010.

In addition, the lack of the Build America Bonds program might mean fewer issuers in the market, but this also could mean, Friedlander said, that yields will likely stabilize because supply will not exceed demand as it did several times over the course of 2010.

BABs may see reincarnation

The BABs program has been popular among issuers that might not otherwise have entered the market.

One issuer reached late in the year said that its $57.27 million sale of BABs will save county taxpayers more than $6 million over the life of the bonds.

Molly Goodman, spokeswoman for the McCracken County School District Finance Corp. of Kentucky, told Prospect News that its school building BABs priced at a 3.709% net interest cost.

"It is estimated that the average interest rate if tax-exempt bonds were issued would have been about 4.45%," she said.

"The interest cost savings to the district by issuing BABs is estimated at over $6 million over the life of the bond issue, a substantial savings over tax-exempt bonds to the district and the citizens of McCracken County."

The bonds (Aa2) were sold competitively with R.W. Baird & Co. winning the bid, and the district plans to use the funds to build a new McCracken County High School.

The bonds are due 2011 to 2026 with term bonds due 2028 and 2030. The serial coupons range from 0.95% to 5.75%. The 2028 bonds have a 6% coupon priced at par, and the 2030 bonds have a 6.125% coupon priced at par.

The district is located in Paducah, Ky.

All may not be lost for BABs, however. Republican representative John Mica of Florida said in late December that he would introduce a reincarnation of the Build America Bonds program to Congress in 2011. He is the new chairman of the House Transportation and Infrastructure Committee.

The proposal, however, may have plenty of Republican opponents. Build America Bonds were not included in a tax package agreed upon by President Obama and Congress.

Issuers flock to BABs

Late in the year, as word that BABs might not live on into 2011 spread, issuers flocked to the market with BABs in hopes of receiving the 35% federal subsidy.

Alan Schankel, managing director with Janney Montgomery Scott LLC, said that 26% of new issue volume was BABs before November, and that market share jumped to 34% for the month of November as issuers ran to take advantage of the program before its Dec. 31 expiration date.

"Reports of action on the extension of the BABs authorization have emerged from the lame-duck session of Congress, including news ... that a one-year extension with a 32% subsidy rate was added to a Senate version of a bill to extend middle-class tax cuts, but given the acrimony surrounding the tax-cut effort, it seems increasingly unlikely that extension will be accomplished this year, and the makeup of next year's legislation does not bode well for the future of the Build America Bond program," he said.

Sifma disappointed

The lack of BABs in Congress' proposed tax legislation for 2011 came as a disappointment to Sifma, and the association has encouraged Congress to reconsider reinstating the program.

Michael Decker, managing director and co-head of Sifma's municipal division, said in a statement that it was "unfortunate that Congress did not include Build America Bonds and other key municipal bond provisions that expire at the end of the year in the proposed tax compromise legislation."

Decker noted in his statement that without the program, borrowing costs to state and local issuers will rise significantly.

"Small communities and nonprofits will be negatively affected by the scaled-back small issuer bank-qualified limit, leaving fewer buyers for their bonds, and issuers of tax-exempt private-activity bonds, including airports and public-private partnerships, will see costs rise significantly if the alternative-minimum tax exemption isn't extended," Decker said in the statement.

Decker wasn't the only public figure disappointed with Congress' decision to omit BABs from the tax package. California treasurer Bill Lockyer said ending the program would inflict injury upon taxpayers.

"If Congress lets it expire, it will damage our economic recovery and inflict a multibillion-dollar injury on taxpayers, not just in California, but in every state in the nation," Lockyer said.

"Some critics in Congress say the BABs program inappropriately subsidizes a state like California. That's ironic, to put it kindly. The taxpayers of California, for years, have subsidized the critics' states, and others, to the tune of billions of dollars."

Yields end year in tailspin

Despite a healthy supply and periods of extremely low yields during the course of 2010, the year closed out in a tailspin, said J.R. Rieger, vice president of fixed-income indexes at Standard & Poor's.

"Yields are under pressure from heavy new issue supply, a difficult economic cycle and failure to extend the Build America Bond program," Rieger said.

"The end result [is] volatility has increased, yields are still rising and bond prices are being pushed down."

Intermediate bonds, Rieger said, have taken the biggest hit. He noted that the S&P AMT-Free Municipal Series 2019 index saw its yields rise by 105 basis points to 3.51%, just about equal to the 10-year Treasury bond yield, since the market high in late August.

"Since its August high, the index has seen a negative total return of 6.62%," Rieger said.

"Year-to-date total return for the 10-year range of municipal bonds has been 4.09%. That 3.51% weighted average yield equates to a 5.4% taxable equivalent yield."

Schankel of Janney Montgomery Scott said that although yields rose sharply in mid-November, tax-free markets recovered somewhat in early December.

"Tax-free bond funds took in an average of $780 million weekly in the first 45 weeks of the year, but the tide turned dramatically for the two weeks ending Nov. 24, which average $3.9 billion in outflows," Schankel reported.

State revenues 'encouraging'

Municipals in general have been under pressure over questions of the creditworthiness of state and municipal issuers, said Schankel.

Despite fears that state revenues would decline, Schankel reported in December that overall state revenue was up 3.9% compared to the same period in 2009.

"Now three quarters into a positive trend, the recent upticks officially fall into the 'encouraging' category," Schankel said.

"The results should aid governments especially at a time when federal support is trailing off, though we remain mindful that state and local government[s] have their work cut out for them in 2011 and 2012. Municipal market observers should prepare for tense budget negotiations at every level of government, especially as politicians posture ... for 2012 elections."

Schankel said that 42 states saw higher revenues during 2010 due to growth in sales and income taxes. That revenue growth was led by North Dakota, which saw 29.5% revenue growth. West Virginia saw 17.8% revenue growth during the year. Meanwhile, Alaska saw its revenues slip a whopping 48.1%. Hawaii's revenues dropped by 13.6% and Louisiana's by 7.5%.

2011 means more work

Despite somewhat improved revenues, states have challenges ahead in 2011, according to analysts from the Center on Budget and Policy Priorities.

Analysts Elizabeth McNichol, Phil Oliff and Nicholas Johnson said in a report released in late December that states will face sharply constrained budgets in 2011 as the recession puts pressure on revenues and state-funded services remain unchanged.

"To balance their 2011 budgets, states had to address fiscal year 2011 gaps totaling $130 billion, or 20% of budgets in 46 states," the analysts wrote.

"Most did so with spending cuts and revenue increases. This total is likely to grow over the course of the fiscal year, which started July 1 in most states. The fact that the gaps have been filled and budgets are balanced does not end the story. Families hit hard by the recession will experience the loss of vital services throughout the year, and the negative impact on the economy will continue."

What's ahead for 2011?

What types of bonds will likely dominate the market in the coming year? Sellsiders agree that if BABs are not resurrected, tax-exempt general obligation bonds will likely be the most-issued bonds over the course of the year, followed by basic infrastructure bonds like water, sewer and transportation bonds.

The problem, however, is that as more fears spread about potential bankruptcies and municipal defaults, retail investors, the bread and butter of the municipals industry, will continue to shy away from all but the highest-rated securities, said one sellsider.

"We're probably going to see more traditional G.O.s in the next year," said the sellsider.

"Problem is, there's still this sense of panic out there, that Small Town America is going broke and is going to default. That's probably not going to happen, but retail investors in a downturned economy do not like to take risks with their money. The BABs program was appealing to foreign investors, and that has helped drive the market this year [2010], but that assistance is not guaranteed in 2011. If it's a safe investment, a triple-A with a stable outlook and a solid economy, most retail investors are going for that. But those types of bonds will become less and less prominent as downgrades continue and municipalities continue to face pressure from smaller revenue streams."

Supply rocks secondary

BABs may have been a great opportunity for small investors to get cheap financing, but the program was so popular that the secondary market suffered, noted some traders reached during the year.

During the middle of the year, the secondary market struggled as more issuers repurchased bonds, and near the end of the year, secondary struggled as issuers flocked to the market with BABs.

"Supply made it tough," said one trader. "When you've got so much coming in, the market just can't digest it all, so secondary really gets knocked around. There were periods when things slowed enough for the market to process it all, but it was a difficult year [for secondary]."

Among some of the more popular trades of the year were the State of California's series 2010-2011 revenue anticipation notes. The state sold $10 billion of the notes in November, but they remained popular with investors in secondary long after pricing, said one trader.

The June 28, 2011 maturity for the notes received nearly $25 million in dollar volume as recently as Dec. 17. On Dec. 17, the 3% notes were seen trading at 1.411%. The notes were priced to yield 1.75%. The average yield for the notes was 1.393%.

In fact, California bonds were extremely popular throughout the year in the secondary market, said the trader.

"California has always been a big name for retail investors, though that did taper off a little near the end of the year," he noted.

"There was a lot of trading volume, not just for state bonds, but for municipalities and authorities out of California."

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