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The investment grade (IG) corporate credit market has followed up the very strong performance at the end of 2023 with a slow, steady grind tighter in spreads so far in 2024. Meanwhile, the high quality Bloomberg Taxable Municipal Index has continued to outperform IG corporate credit this year on a spread and excess return basis. However, within the taxable municipal index, Build America Bonds (BABs) have recently been a notable laggard.
BABs were introduced during the Global Financial Crisis (GFC) (via the American Recovery and Reinvestment Act of 2009) as a means for issuers to access capital because the traditional tax-exempt market had essentially shut down at that time. BABs are a taxable municipal product where the federal government covers a portion of the issuer’s interest cost. The program, which was closed at the end of 2010, was a very effective tool during the GFC as it tapped a much larger and deeper investor base in taxable credit. Issuers continue to borrow in the (non-BAB) taxable municipal market, although generally in low volumes, with only about $30-$40 billion issued annually.1
Many BABs issued during the GFC contain an optional Extraordinary Redemption Provision (ERP) which would be triggered if the federal subsidy was cut. In most cases, the issuer would be eligible to redeem the bonds at the higher of par or +100 basis points (bps) spread versus comparable Treasuries. With the passing of the Budget Control Act of 2011, which went into effect in 2013, the federal subsidies were decreased as a result of automatic spending cuts (sequestration). The cuts are in effect to this day, albeit at a slightly lower level (~5%).2 This effectively made BABs with the ERPs eligible to be called since 2013.
The strong spread performance in taxable municipal bonds this year had included BABs trading through the 100 bps ERP spread. With the tax-exempt market trading at tight levels, the economics for some issuers in exercising the ERP and refinancing in the tax-exempt market has been quite compelling. As a result, there have been over 3.6 billion in bonds (year-to-date) where the ERP was exercised.3 Other issuers have announced they are considering the ERP as well — potentially another five billion bonds.
Today’s Chart of the Week highlights how the increase in ERP calls has led to Bloomberg BAB Index spreads widening to +100 bps context after being inside of 90 bps in February. As displayed in today’s chart, the average dollar price of bonds in the BAB Index is $109. In the past year, BABs have now lagged the overall Bloomberg Aggregate Eligible Taxable Municipal Index by approximately 22 bps.
Key Takeaway
Given the lack of BAB ERP calls in the past decade, many market participants viewed the possibility of any meaningful bond redemptions as unlikely, and spreads recently traded well through the ERP level. It has proven unwise to chase many BABs through the ERP as bonds have been taken out. While court challenges related to the legality of the call emerged, a federal claims court ruled that sequestration does constitute an ERP event. BABs trading through or near the ERP level seem ripe for being called, given the sizable cost savings in refinancing in the tax-exempt market.
Sources:
1,2Barclays
3J.P. Morgan
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