By all accounts, the new taxable municipal bond program known as “Build America Bonds” (BABs) has been an enormous success. However, as with any new program, there are some wrinkles that need to be ironed out.
Ambiguous comments from the Internal Revenue Service have raised concerns among both issuers and investors that some states or cities could lose the federal subsidies that bolster this fledgling market. We think their anxiety will prove to be overblown.
The program, established last year under the American Recovery and Reinvestment Act (ARRA), reimburses general governmental issuers for 35% of their interest costs for new qualifying taxable bond issues. It was viewed as a major initiative to stimulate government spending and save jobs in a rapidly weakening economy. Indeed, about $104 billion of BABs were issued through the middle of last month, producing an estimated savings of $12 billion in interest costs for state and local governments in the first year alone.
However, the program was enacted quickly without the usual “fine print” detailing how the interest subsidies would be applied. Now, questions are being raised regarding its administration.
IRS oversees program
The BABs program is overseen by the Internal Revenue Service. Although the IRS is effective in collecting revenues and apprehending tax cheats, it has little experience in program administration.
Since the IRS is fundamentally a collection agency, the BABs program has been structured to fit the IRS’ core competency. The IRS administers BABs through treatment of interest subsidies as tax refunds. Issuers must meet certain criteria to sell BABs, and in order to receive their subsidy check, they must file IRS forms within a designated time period prior to each interest payment date.
The surprise to issuers has been the IRS’ enforcement of federal law requiring tax refunds to be net of any funds owed and outstanding to the federal government. Unless Congress changes this law (which applies broadly), subsidy checks for some governmental units will be smaller than expected. The good news is that, so far, such withholdings have been extremely small. Also, when rating BABs, the rating agencies have taken a conservative posture in assuming that an issuer receives no subsidy at all. Since the vast majority of BABs issuers to date have been larger states and cities with strong credit profiles, the subsidy withholding issue has proved to be minor.
The second recent concern results from another IRS function: compliance with the tax code. In this case, the IRS has indicated that its compliance efforts will focus on a tax law requirement that BABs cannot be sold for more than a small premium at their initial sale. Issuers are concerned that too high a premium could disqualify the bonds as BABs and nullify the interest subsidy.
Backtracking on initial warnings
Fortunately, senior legal counsel within the IRS took great pains to backtrack on its initial warnings and have indicated that issuers’ concerns are greatly exaggerated. The IRS, according to this official, noted that issuers following existing guidelines will not be penalized, and that any future changes will not be made without public notice and the opportunity for public comment.
In any case, bondholders should feel no pinch since the bonds are secured in the same manner as their tax exempt counterparts, eliminating the fear of a bond being declared taxable – since they already are. Analysts at rating agencies and in the municipal bond industry have agreed that the analytical approach to BABs should assume there is no interest subsidy and the bonds should be well secured even in this worst case scenario.
Investors who are utilizing these taxable municipal bonds in their IRAs, pensions and other tax-deferred accounts can be confident that workable guidelines are being established as the program ages and are likely to see continued refinements as the Build America Bond initiative evolves.