The recently announced bipartisan congressional agreement calls for $1 trillion in infrastructure spending. Admittedly, the agreement has a long way to go given the Democrats’ demands to pair the legislation with a reconciliation bill of progressive policies. While the deal in its current form is unlikely to be the final version, certain aspects could impact the municipal bond market.
Included in the agreement was the use of direct-pay bonds to fund a portion of the infrastructure investment. This type of program was used effectively during the financial crisis, when municipal issuers raised funds in the taxable market and the federal government subsidized the interest cost through the Build America Bond (BAB) program. Many participants in the market are excited that this type of program, if enacted, could lead to a meaningful pickup in taxable municipal issuance — but will it?
The BAB program utilized a 35% federal subsidy on new-issue taxable municipal interest costs before the program expired in 2010. Details on the level of a subsidy in the proposed direct-pay program were not mentioned in the recent agreement. Today’s chart highlights the market-implied breakeven subsidy for 30-year municipal paper. The graph shows the federal subsidy required on taxable debt for the municipal issuer to be indifferent about whether the issuance occurs in taxable or exempt form. The breakeven subsidy for AA-rated municipal credit is currently over 40%, while the A-rated subsidy is 35%. For shorter maturities, the breakeven subsidy is substantially higher. Previous conversations in Washington regarding subsidy levels for a direct-pay bond program were generally around 30% or less. As a result, with subsidy levels likely less than 35%, the potential for large issuance of taxable municipals is likely to disappoint — it is more economical for municipal issuers to borrow in exempt form.
Key Takeaway
The previous BAB program was implemented at a time when the exempt market was trading at very high yields, as the retail investor had no bid during the financial crisis. Therefore, this program was extremely successful in providing municipal issuers with access to capital. Today, the exempt market is trading at or near all-time tight levels. Certainly, this relationship can change by the time any direct-pay program may be implemented, but the current relationship does not indicate a wave of taxable municipal issuance is on the horizon.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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