Every so often Congress is asked to consider legislation that would authorize state and local governments to issue tax credit bonds as a supplement to, or replacement of, tax-exempt municipal bonds. While some outstanding tax credit bonds were structured with the goal of having the tax credit fully compensate investors, with no interest payments required of the issuer, most recent proposals envision bonds that would pay taxable interest at a rate that would be reduced because of accompanying tax credits (computed as a fixed percentage of each interest payment).
One objection to the use of tax credit bonds is that, when appropriate benchmarks are used to compare the costs of tax-exempt and taxable bonds, tax credit bonds are no more effective than tax-exempt bonds in lowering issuers' costs. Another objection, which has received less attention, is that tax credit bonds would be unattractive to investors, and expensive for issuers, because of the complexities involved in keeping track of who is eligible to use the tax credit.
To be of any interest to investors, tax credit bonds must fulfill two criteria:
- They must be transferable, and
- It must be possible to trade the credits separately from the interest-bearing bonds.
Transferability is necessary since investors cannot be sure of their tax liability years into the future, and markets exact a high premium for illiquid instruments. The ability to strip the credits from the bonds is necessary because tax-deferred accounts that can efficiently invest in taxable bonds typically have little or no use for tax credits, and taxable accounts that can benefit from tax credits typically have little or no use for taxable bonds.
To make it possible for tax credit bonds to fulfill the above two criteria, the Internal Revenue Service has specified the procedures that issuers and holders of tax credit bonds must follow (Bulletin 2010-15, April 12, 2010, Notice 2010-28,
- Each quarter issuers must send form 1097-BTC to each holder of tax credits, and must file with the IRS a copy of each form, which includes the name, address and federal identification number of each holder. Municipal issuers do not currently keep track of the owners of municipal securities, and creating the infrastructure for such tracking would entail considerable costs.
- For each quarterly date on which a tax credit accrues to the holder of record, the issuer or the party stripping the credits in the secondary market must obtain a separate security identifier (known as a CUSIP). Treating each tax credit for each quarterly date as a separate security means that for a bond due in ten years, an issuer or subsequent purchaser would have to secure one CUSIP for the bond with credits attached, one CUSIP for the coupon-bearing bond apart from the credits, and 40 CUSIPs for the individual tax credits.
The need for so many CUSIPs creates several difficulties. The multiplicity of CUSIPs would:
- Increase the cost of obtaining CUSIPs for a financing.
- Increase the cost of pricing the various tax credits on a regular basis (which would be a daily requirement for any mutual fund that invests in tax credits).
- Increase the cost of tracking the holders of tax credits since the potential number of different holders would increase.
- Reduce the dollar value of each tax credit to the point of being infeasible as an investment vehicle. For example, if a fully taxable bond due in 10 years yields 3.50%, a comparable tax credit bond with a credit equal to 25% of the interest received would have a theoretical yield on a taxable-equivalent basis of 2.80% (both the tax credit and the interest received are taxable income). On a par value of $2 million, the issuer would make interest payments of $56,000 per year, or $14,000 per quarter, which would generate tax credits of $3,500 on each quarterly tax credit date. The present value of the final $3,500 payment due in 10 years would be $2,470 (compounded quarterly at a 3.50% rate). Securities with such miniscule trading values could not be efficiently managed in an institutional portfolio.
Another consideration apart from the problems associated with the number of CUSIPs for each tax credit bond is the difficulty issuers would have in selling bonds with traditional optional redemption provisions since tax credits for dates after the first call date would have to be priced with consideration for the likelihood that the bond might called and the credits thus rendered worthless.
In summary, since each quarterly tax credit for each maturity of a municipal bond issue would be treated as a separate security, with its own cost basis, the costs of issuing, trading and managing portfolios of tax credit bonds would cause such securities to be unappealing both to issuers and investors. Even if state and local governments had the staff and technology needed to comply with the requirements for tax reporting, these disadvantages would increase issuers' costs to the point where issuing such bonds would be uneconomical.
Cadmus M. Hicks, CFA, PhD, is managing director, manager of performance and risk analysis, and market strategist at Nuveen Asset Management.
