Business Insider

Peter Crabb: A temporary federal bond subsidy used by local governments carries risks

Time is running out. Cities and counties, including Canyon County, are rushing to finance new projects before a subsidy from Washington expires.

Federal subsidies to local governments for interest payments on debt will expire at the end of this year. The economic stimulus plan of last year (the American Recovery and Reinvestment Act of 2009) included a provision called the Build America Bond (BAB) program.

BAB allows state and local governments to issue taxable bonds for financing all types of construction projects, like roads, schools, and water treatment plants. The municipality or state agency lowers its interest cost for the project by about one third, the portion paid by the U.S. Treasury.

The Treasury reported last month that financial markets are giving Build America Bonds a “very positive” reception. Since the program began in April 2009 more than $106 billion in bonds have been issued in 49 states constituting 21 percent of the municipal bond market.

Despite the slow economy the municipal bond market is doing well overall. The Municipal Bond Index is up nearly 4 percent and the average rate on municipal bonds fell from 5.4 to 5.1 percent since the start of the year.

With good rates for the borrower and the subsidies scheduled to expire in December banks are scrambling to get the bonds issued and sold. The program has helped the beleaguered banking industry by providing a safe borrower in local governments with a lending instrument that produces good fee income. Bank fees for selling municipal bonds have risen on average 20 percent according to analysis by The Bond Buyer magazine.

Congress is considering an extension of the program, but just in case, the race is on to get bonds sold.The city of Chicago is getting ready to issue up to $2 billion of taxable BABs before program expiration at year end. The University of Nebraska is working and the city of Lincoln to sell up to $100 million BABs next month for a new arena.

Canyon County is holding a special election August 3 to insure there is enough time left in the year to sell BAB bonds for a proposed new jail. Even this date leaves just a few days at the end of December for bankers to get the bonds sold in time for the interest cost subsidy.

BABs are not, however, without risk for either the buyer of the bond or the issuer. In May, the state of Florida permanently suspended the sale of any new BABs because the U.S. Treasury withheld some of interest subsidy. The federal government was disputing what Florida owed under different programs. Cities in Texas and California have also had subsidies withheld.

A potentially bigger risk for the buyers of BABs is that of liquidity. As a brand new market there are not as many of these bonds trading as in the $2 trillion market for traditional municipal bonds. If the program ends as scheduled BAB liquidity will remain very low.

Both buyer and seller beware. Buyers will have to judge investment risk accordingly but the state, county, or city selling the BAB also must watch the risk of changes or hold-backs from Washington.In the long run investors and municipalities are likely better off with traditional municipal bonds.

Peter R. Crabb is a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon.