September 17, 2012 / 6:32 PM / 5 years ago

Possible federal cut to Build America Bonds chills munis

Sept 17 (Reuters) - The prospect of Build America Bonds losing a slice of federal funding if automatic spending cuts are carried out next year sent a chill through the U.S. municipal bond market on Monday.

A 394-page document released by the White House on Friday listing a breakdown of spending cuts showed the Treasury could reduce the 35 percent federal rebate to issuers for interest costs on $181 billion of debt issued between April 2009 and December 2010 to save $255 million.

The rebate payments authorized for fiscal 2013 would be reduced by 7.6 percent, according to the report. The BABs program ended in December 2010.

Investors in the $3.7 trillion muni market generally viewed the rebate as a big help for states, cities and other issuers to make payments on the taxable debt, which has been a stellar performer in the fixed-income market.

"(Issuers) wouldn't have been able to sell the bonds if there was any doubt to the willingness (of the federal government) to put up the money," said Chris Mier, a managing director at Loop Capital Markets. "I think the market was under the impression that this stuff was pretty well iron-clad."

A potential cut in the federal subsidy had been a worry when the program began. A cut now will leave issuers on the hook to make the interest payments without having fully budgeted for the money.

"Net net this will put pressure on issuers," said John Hallacy, municipal market strategist at Bank of America Merrill Lynch. "The question is: how are they going to come up with the money?"

California was the biggest seller of BABs at $13.8 billion of debt and would lose $16.2 million this fiscal year if the rebate is cut, according to Tom Dresslar, a spokesman for State Treasurer Bill Lockyer.

"It's not a death blow to our budget but it certainly does not help," Dresslar said.

While larger entities may be able to absorb the higher payments, smaller BAB issuers, with more limited revenue could struggle.

"When you get down to smaller issuers you worry. There could be a delay in payments," Mier said.

The 35 percent federal rebate, which enticed many issuers to sell BABs, is a potential victim in what is called in Washington the "sequestration" plan along with automatic spending cuts to Medicare and national defense.

BABs, which have been be popular with issuers and investors, were created in a 2009 law as a way to boost state and local government infrastructure spending and stimulate the weakened economy.

Because BABs were sold on a taxable basis, the new kind of debt brought in nontraditional muni investors attracted by the higher yields and relative safety of the market.

So far in 2012, BABs have had total returns of 8.293 percent, a far richer mix of price increases and interest payments than U.S. Treasuries and tax-free municipal bonds, according to Bank of America Merrill Lynch data.

Treasuries have so far this year posted total returns of 1.677 percent and munis 5.766 percent, according to Merrill. Only corporate high-yield bonds, with 2012 returns of just under 12 percent, have bested BABs among major types of debt securities.

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