Build America Bonds Can Rebuild Muni Market

Congress Should Act to Bring Them Back

Sen. Orrin Hatch (R-UT), the top Republican lawmaker on the Senate Finance Committee, has vowed to block President Barack Obama’s proposal to permanently revive the Build America Bonds program, calling it a “nonsensical provision” in his recently announced budget for fiscal year 2012. Yet nothing could be further from the truth. Build America Bonds reduced inefficiency and waste in the municipal bond market, saved taxpayers money, and promoted long-overdue infrastructure investment.

Congress can help stabilize the municipal bond market now by reintroducing the Build America Bonds program, which Congress failed to renew at the end of 2010 despite a successful two-year track record. Build America Bonds—taxable bonds in which the federal government directly subsidizes a portion of the issuer’s interest costs—will expand the municipal market to more investors at a time when demand for traditional tax-exempt bonds is weak.

In fact, some of the weakness in the muni market is attributable to the end of the Build America Bonds program. “The muni market is dependent on a precariously thin base of demand in the aftermath of the demise of Build America Bonds,” says Citigroup municipal analyst George Friedlander in a Bond Buyer article earlier this month.

Indeed, tax-exempt yields are at their highest in a year and investors have pulled record amounts of money from the mutual funds that invest in tax-exempt bonds. Budget-constrained issuers, such as the state of Wisconsin, are now paying up to two-thirds more to borrow than they did last year when they had the option of issuing Build America Bonds, according to data compiled by Bloomberg.

Weak demand for municipal bonds means state and local government’s borrowing costs will rise. That will lead to higher taxes for residents, or fewer critical investments and services. Or both.

Build America Bonds, by contrast, lower borrowing costs. The Treasury Department estimates that state and local governments had saved more than $12 billion in present value from issuing the direct-subsidy bonds.

Muni bonds’ most attractive feature—tax-free interest payments—are also their fundamental weakness. Municipalities are forced to sell predominantly to buyers that would benefit from the tax exemption, namely individual retail investors. The problem is that these investors tend to prefer shorter-term instruments that shield their income from taxes. They don’t like tying up their dollars in the longer-maturity bonds that state and local governments need to finance long-term projects. This means state and local governments must either issue debt at shorter maturities or pay higher interest rates to get people to invest their money and wait out long maturities.

Build America Bonds investors are more willing to buy longer maturity bonds, according to a study by Vineer Bhansali, managing director at PIMCO, the nation’s largest bond investor. That’s because they appeal to income tax-indifferent institutional investors, such as endowments and pension funds, which also have longer investment horizons.

Even as the muni market is roiled by turbulence, demand remains strong for existing Build America Bonds in the secondary market. The spread between Build America Bonds and comparable Treasuries has decreased 20 basis points this year, according to a Wells Fargo index. That shows institutional investors have not bought into the panic. And it’s yet another reason to broaden the municipal bond market through Build America Bonds: immediate access to a more stable base of investors.

What’s more, the tax-exempt market will benefit from a permanent Build America Bonds program. Why? Because the availability of Build America Bonds as an alternative form of financing reduces supply pressures in the tax-exempt bond market. That allows issuers to offer tax-exempt bonds at lower yields. Ultimately, the beneficiaries of a robust, stable municipal bond market are the taxpayers of communities across the nation.

Congress is wise to pay close attention to the municipal bond market because it is central to governments and the communities they serve. But before it starts exploring drastic and potentially devastating ideas like expanding bankruptcy protection to state governments, as some have proposed, it should try something that has worked. Congress should take up the president’s proposal and bring back Build America Bonds. Failing to do so would truly be nonsensical.

Jordan Eizenga is an Economic Policy Analyst at the Center for American Progress.