Well, the government has done it again. Yes, federal subsidy payments to issuers of Build America Bonds (BABs) and other direct-pay bonds will be cut by 6.8% in fiscal 2016. Again due to sequestration, this cut follows two others on the BABs in recent years: 7.3% in fiscal 2015 and 7.2% in fiscal 2014. According to officials, fiscal 2016 cuts are lower due to Medicare and its growing costs. Specifically, sequestration necessitates about $109 billion of cuts divided evenly between defense and nondefense programs. As such, a little over $54 billion for nondefense programs is divided between discretionary programs and entitlements such as Medicare. Since Medicare sequestration cuts are capped at 2% of its costs and due to the rising costs of Medicare, more of the $54 billion comes from entitlements than from the discretionary programs.
So, how does this affect bonds? The reduction of the subsidy allows issuers of BABs to redeem bonds early. This has caused some issuers to follow through and actually redeem; however, most have simply reminded bondholders that they have the right to redeem their bonds, flexing their muscles to an extent.
Now, let’s take this opportunity to explain exactly what this Extraordinary Redemption Provision (ERP) is and how it differs from a structured call provision. BABs, like other municipal bonds, typically have standard call features. This means they have the right but not the obligation to redeem a bond prior to its stated maturity according to the call schedule stated in the prospectus. As far as the BABs are concerned, the first call dates are typically 2019 or 2020 (10-years after their issuance in 2009 and 2010). An Extraordinary Redemption Provision (ERP) goes above and beyond the regular call. For BABs, if the government reduces the issuer’s subsidy (which has already happened) the bonds can be redeemed at ANY TIME. Moreover, any holder of BAB municipal securities currently has some element of risk under this extraordinary provision.
While risk is present, this has been a possibility since initial issuance. As previously stated, this is the third reduction in the subsidy and only a handful of issuers have executed their right under this provision. More specifically, there have been $188 billion total of BABs issued. Of this amount, only 10-20 issues have actually been redeemed under this provision, with the largest issue being $100MM. Ultimately, far less than 1% of all BABs have been redeemed under the ERP due to the reduction of government subsidy. This is the place where I give you the advisor disclaimer: “past performance is no guarantee of future performance.” In this case, translate that to mean simply because many issuers have not exercised their right to prematurely redeem under this ERP does not mean they will not. With that said if interest rates rise the ability to refinance these issues at low interest rates diminishes. There is still risk and even though it may be limited this decision lies in the hands of the issuing municipality. In theory, as rates rise the flexibility to refinance this debt reduces as the interest burden is greater on the municipality.
The specific details of each issue’s provision vary. Some can be redeemed at a specific spread to a U.S. Treasury while others dictate a stated price, usually par or a slight premium. With that said, the lower the redemption price, the greater the risk in theory as it makes the redemption less expensive for the issuer. For instance, redeeming a bond at par would be cheaper for the municipality than paying a 100-basis point spread over a 30-year Treasury (considering the coupons of the BABs). Since interest rates are low prices are higher. Additionally, depending upon when the BAB was purchased (whether in the new issue or secondary market and at what point over the last six years), the book price of the issue may be at a premium. Moreover, if the bonds are redeemed at a lower level (closer to par) the more likely it is for a loss to be realized. Another aspect of risk to consider is whether the issuer has the ability to exercise their ERP right (at whatever respective price) and re-issue as a tax-free municipal. This throws another variable into the mix that is also difficult to ascertain and determine a mathematical answer as to whether it makes sense for the issuer or not.
All of this information is to say: know the risk in your portfolio. If you are loaded up on BABs, know the specific ERP details of each. It is not our stance that BABs are or have been a poor investment; after all no return can come in excess of the risk free rate without some form of risk. However, the purpose of this article is to inform the reader of the situation as well as help you become familiar with the risk.
If you need assistance ascertaining the specific Extraordinary Redemption Provision risk of the Build America Bonds within your portfolio, please do not hesitate to give us a call.
Disclosures
Parkway Advisors, L.P. is an investment advisor registered with the Securities and Exchange Commission offering investment management, consulting, and statutory reporting services. This material is for your use only and has not been independently verified and thus we do not represent that it is complete and should not be relied upon as such. The opinions expressed are our opinions only. Past performance is no guarantee of future performance and no guarantee is made.
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