Muni yields fall as issuers turn to U.S.-backed bond plan


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California today became the biggest issuer so far of a new type of municipal bond that has caused investors to rethink the muni market overall -- in a way that is driving down yields on the bonds.

The state, as expected, said it sold $6.85 billion in muni bonds to finance voter-approved infrastructure projects. Included in the deal are $5.23 billion of securities sold under the federal government’s new Build America Bonds program, part of the economic-stimulus package Congress approved in February.


Unlike conventional munis, which pay interest that is exempt from federal income tax, Build America Bonds are subject to federal tax. That means California paid a higher gross yield on the bonds than it would have paid on conventional munis.

But the state still wound up saving money, because the federal government picks up 35% of the interest cost of bonds issued under the Build America Bonds plan.

Example: California paid an annualized yield of 7.4% on the $3 billion of 30-year bonds in today’s offering. With Uncle Sam paying 35% of that, the net yield paid by the state is 4.8%.

That is well below the current 5.65% market yield on recently issued 30-year California tax-free bonds.

Lockyer estimated that the Build America Bonds in today’s sale will save the state $1.15 billion in interest over the next 30 years, compared with conventional munis.

For investors, the launch of the Build America Bonds program has stoked a rally across the tax-free muni bond market over the last week, driving bond prices up and yields down.

The yield on the Bond Buyer index of 40 long-term tax-free muni bonds nationwide sank to 5.36% on Tuesday, down from 5.56% a month ago and the lowest since September.

Why the rally? One expectation is that rising issuance of taxable bonds by state and local governments under the Build America Bonds program will mean fewer conventional munis coming to market this year. So some investors are grabbing what they can.

‘There’s a fear that this is going to create a shortage of large, long-[term] tax-free issues,’ said Ben Stern, a principal at muni bond investment banking firm De La Rosa & Co. in L.A.

There’s something else going on as well: The yields that investors are accepting on the taxable Build America Bonds are forcing conventional-muni investors to reconsider what is, in effect, a fair yield on tax-free bonds. The market now is saying that investors have been demanding too much of tax-free issuers, including credit-rating-impaired California.

‘This is like a refocusing of the muni market,’ said Matt Fabian, senior analyst at consulting firm Municipal Market Advisors in Westport, Conn.

It’s a boon for California and for investors who already own muni bonds. But investors who’ve been waiting to buy munis now are finding that the yields they can get are dwindling, although they remain historically high compared with yields on other bonds, such as U.S. Treasuries.

-- Tom Petruno