California, which has the lowest credit rating of any state in the nation, was shut out of the debt markets for much of 2008, forcing Governor Arnold Schwarzenegger to announce in December that he was halting work on 5,000 construction projects. Yet thanks to a new federal subsidy, the Golden State was able to return to the market with a splash in April. Notwithstanding a lowly single-A rating from Standard & Poor’s, California issued $6.85 billion in bonds, the biggest issue in its 158-year history and the fourth-largest offering ever by a U.S. state or local government.
California was the first of many public borrowers rushing to take advantage of the Build America Bond program, which subsidized $5 billion of the April issue. By offering interest rate subsidies, the federal economic stimulus program helps municipal bond issuers such as California move beyond their traditional tax-free market and tap the much larger taxable bond market, reducing their interest expenses and thereby facilitating public works projects that benefit the economy. The state’s BABs were bought by more than 200 investors, including sizable money managers, insurance companies and pension funds. “A much larger pool of liquidity is available to states and municipalities issuing under Build America than in a typical municipal bond offering,” notes James Esposito, head of municipal and investment-grade financing at Goldman Sachs Group, a co–lead underwriter on the deal. The primary investment-grade bond market is about twice the size of the primary muni market. “We’re seeing traditional investment-grade buyers participating in these deals, and many of these investors have not participated in municipal bond offerings previously,” he says.
The BAB subsidy allows issuers to offer a premium, which helps attract capital. The California BABs, which carry 25- and 30-year maturities, yield 7.43 percent, or 365 basis points over 30-year Treasuries. In comparison, in April, Verizon Communications issued a $1 billion A-rated 30-year bond yielding 7.35 percent. “The 365 basis points over Treasuries looks to be a very attractive deal relative to securities in the corporate space in the A-rated category, as well as other sovereign debt,” says Joseph Gotelli, a portfolio manager at American Century Investments, which manages about $3 billion. His fund bought $5 million worth of the California BABs.
Projects with BAB funding are sprouting up nationwide. The New Jersey Turnpike Authority sold $1.38 billion of BABs in April to help fund a $7 billion, ten-year capital plan for infrastructure improvements, including $2.5 billion to widen parts of the Garden State Parkway by an additional lane in each direction. At the University of Virginia, a $250 million BAB issue will pay for a research building at the college of arts and sciences, a building for the engineering school and a clinical cancer center. The university calculates that it will save $2.1 million in interest payments thanks to the federal subsidy. BAB issues, which totaled $7.4 billion in April, could top $40 billion this year, according to Philip Fischer, a muni market strategist at Bank of America–Merrill Lynch. There’s no limit on the size of the program, although the bonds must be issued in 2009 or 2010.
BABs give credit-challenged issuers two options for relief, both of them taxable. The bonds can provide holders with a 35 percent tax credit, or they can subsidize 35 percent of the issuer’s interest. So far all of the participants have opted for the interest subsidy. “We shut down all sorts of projects in December, including highways, flood control, housing, parks and schools, because we didn’t have the money in the bond accounts. The BABs have gotten all of them going again,” California State Treasurer William Lockyer said in an interview with Institutional Investor . He says BABs will create or save 18,000 jobs for every $1 billion in debt.
The state paid a net 4.83 percent interest rate, about 82 basis points lower than the prevailing rate for comparable tax-exempt bonds at the time of issue. Lockyer said BABs will save California taxpayers $1.1 billion to $1.7 billion that can be pumped into the ailing economy — and not a moment too soon.
