* Federal rebate had been considered iron-clad
* BABs issuers face higher debt service costs
* Smaller issuers likely to struggle
By Karen Pierog and Michael Connor
Sept 17 (Reuters) - The prospect of Build America Bonds losing a slice of federal funding if automatic spending cuts under the so-called fiscal cliff are implemented next year sent a chill through the U.S. municipal bond market on Mon day.
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 BABs program, which was made part of the 2009 economic stimulus as a way to boost state and local government infrastructure spending, 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. Many issuers, which were already facing sagging revenue, would be 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 could struggle.
"When you get down to smaller issuers you worry. There could be a delay in payments," Loop Capital's Mier said.
Stevens Point, Wisconsin, one of the first issuers of BABs, sold about $11 million of the debt backed by its general obligation pledge in three deals. The smaller federal payment will cost the city thousands of dollars more for debt service, according to John Schlice, the city's comptroller and treasurer.
"What they are doing is passing the problem to the local level and local taxpayers," he said.
Kristin Franceschi, president of the National Association of Bond Lawyers, said the rebate cut is likely to pose a bigger problem for BABs backed exclusively by revenue from a government enterprise, such as water and sewer systems. Rates for the services may incorporate the full BABs payment, leaving the issuer short on debt service funds, she 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.
Nevada State Treasurer Kate Marshall said a big portion of the spending cuts is aimed at state and local governments.
"It is not a cost saving at the end of the day if you are simply shifting those costs from one part of the public sector to another," said Marshall, who also heads the National Association of State Treasurers. Florida, which sold about $1.3 billion of BABs for roads and schools before calling a halt to the deals in early 2010 out of worries Washington would one day falter on its subsidy payments, should be little affected by any reduction, according to state Bond Director Ben Watkins.
"I don't think it will have a material impact on credit structures. Two hundred and fifty five million is not a lot relative to the overall annual subsidy," he said.
Some issuers reserved the right to redeem their BABs should the federal subsidy be reduced or even eliminated, a provision that financial advisers had been pushing in 2010, Franceschi said. But she noted that make-whole redemptions could end up being a costly move.
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.
On Monday, BABs prices were steady in secondary market trading, according to Municipal Market Data. Other muni debt that could face federal payment reductions are qualified zone academy, qualified school construction and qualified energy conservation bonds.