As you know, municipal debt is usually tax exempt (not always, as is commonly misunderstood). Thus the IRS collects nothing on whatever interest income individuals realize out of municipal bonds. Since its mostly the wealthy who buy munis, that’s about 35% in taxes not collected.
But here is the problem, individuals can only buy so many bonds. For most of the last 10 years or so, any excess supply from municipalities was soaked up by TOBs. Now those programs are all but extinct, and individuals can’t take up the slack.
The Federal government has put forth “Build America Bonds” (BABs) as an alternative. See, while individuals aren’t buying enough bonds, pension funds, money managers, and even sovereign wealth funds are dying for long-term bonds that let them sleep at night. Currently there isn’t much in the corporate bond world that fits that bill. State and local governments are much safer. As I’ve written before, a municipal default has very little in common with a corporate default, so even if we assume that municipalities will suffer through more stress than any time since the Depression, its still a relatively safe market.
The Treasury gives the municipality a 35% rebate on the interest cost of a BAB. So if the municipality issues bonds at 6% with, the Treasury will rebate the municipality 2.1%. This allows non-tax paying institutions to buy the municipal debt with taxable-type yields.
Buying in BABs has been extremely aggressive. We saw the New Jersey Turnpike issue bonds maturing in 2040. They were issued at $100 on 4/20, traded as high as $106 that same day! Of course, California’s huge $6.8 billion deal stole the thunder. I myself tried to buy $6 million and got zero. Meaning the bond was in such hot demand, they didn’t give me a single bond. Either that or its J.P. Morgan (who underwrote the deal) giving me a giant middle finger. Right back at you Dimon…
Anyway, these bonds aren’t for you. Don’t buy them in the secondary. Its fine if you are a pension fund or some other entity with long-dated liabilities. In fact, I think these bonds are perfect in those circumstances. But for every one else, stick with more liquid intermediate-term securities. I’ve been trading taxable municipal bonds my entire career, and trust me when I say the liquidity isn’t there. So these bonds have to be mostly buy and hold bonds. Which is fine, but do you want to be buy and hold for the next 30 years?
By the way, the reason why BABs are currently only long-term bonds is because that’s where the municipal yield curve is widest vs. the Treasury curve. In shorter bonds (say inside of 20-years) a classic municipal bond issue makes more sense for the issuer.
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