Back in the headlines, BABs cheapen, offer opportunity despite call risk

Spreads on Build America Bonds have widened "significantly" in the last few months amid a wave of refinancings despite a debate over the legal ability of issuers to call the debt, according to municipal bond strategists.

So far this year, the BABs index option-adjust spread has cheapened 10bps compared to the ICE Broad Taxable Municipal Bond Index OAS, BofA strategists noted in a Friday report.

"There is no particular reason other than the much-debated ERP refunding," BofA said. So far this year, issuers have brought $4 billion of BABs to market for a refunding, BofA said. The pace quickened in April, with $2.4 billion brought to market in just the first two weeks of the month, the bank said.

The strategists noted that the BABS index includes par value of $97.6 billion compared to the TXMB's $374 billion of par value. "The overall impact on the BABs index is a larger index price decline than for TXMB," the report said.

After years of little refunding activity on the pricey and popular paper, the market has started to show sizable savings for issuers who replace BABs with tax-exempt debt. The pace of the refundings has also picked up after a court decision ruled that repeated budget sequestration cuts to the 35% interest subsidies constitute an "extraordinary" event that allows issuers to call the debt.

The refinancings have sparked controversy among investors, who have challenged the transactions, arguing that sequestration does not qualify as an extraordinary event, and have even threatened to sue issuers who replace their debt.

BABs with ERP calls make up about 13% of the taxable municipal market, according to Appleton Partners Inc.

Even "if nothing comes out of this legal challenge, and the trend of calling BABs will continue unabated, we still find various types of direct-pay bonds that are worth buying even now, as their risk of being called is low, in our view," said Barclays strategists in an April 12 note.

The majority of BABs have ERPS that are "struck at T+100bps," noted Barclays. Spread calls of all bonds that are trading wider than that "are out of the money, and these bonds are worth buying if investors are not concerned about their credit quality."

In addition, all low-coupon BABs that are trading below par are attractive, as their holders will only benefit if the bonds are called, strategists said. "However, investors should be aware that if rates rally, and the price of the bonds jumps over par, the risk of it being called below the market price will increase, and its spreads might widen as a result."

Barclays named as an example of value BABs issued by MEAG Power for its Vogtle nuclear plant, that are trading wider than T+100bp, noting that the Vogtle 3 project has already started operating, while the Vogtle 4 should be finished early next year.

The Bloomberg BABs Index has seen spreads widen to over 100bps from inside 90bps in February, James G. Faunce of Penn Mutual Asset Management noted in a Thursday blog post titled "Not so Extraordinary BABs." The average BABs price in the index is $109, Faunce noted. While the Bloomberg Taxable Municipal Index has outperformed the investment-grade corporate market so far this year, within the taxable muni index BABs have recently become a "notable laggard," Faunce said.  

Western Asset in an April 9 blog titled "Bye-Bye BABs?" noted the potential value for investors willing to take on the call risk, but added that the firm expects that ERP call activity "could remain limited."

Partly that is because the attractive tax-exempt relative valuations are restricted mostly to the AAA group, the firm said, and issuance costs could dampen the positive benefits. "Last, we believe issuers could question whether the sequestration of BABs subsidies qualify as an ERP event, and may ultimately determine that costs associated with legal challenges could outweigh positive economics associated with the refinancing."