Sequestration Affects Build America Bond Issuers

by Matthew D. Jessup on March 6, 2013

The talk-of-the-town the past two weeks in Washington DC and around the country has been about sequestration. You can’t turn on the television or “open” a newspaper on your iPad without hearing about it. The federal budget cuts that took effect March 1, 2013 affect defense spending, air traffic controllers, and now even tours at the White House.

One impact not widely publicized is that on the governmental issuer of municipal bonds and, more specifically, Build America Bonds, or BABs. Sequestration has cut by 8.7%, the direct pay subsidy expected by local government issuers of BABs. That means any local government issuer of BABs should expect an 8.7% reduction in the “BAB revenue” it is likely anticipating in its 2013 budget.

BABs were created by the federal government in 2009 as part of the American Recovery and Reinvestment Act. Though many types of BABs were created, most New Jersey local governments (and governments country-wide) issued “direct pay” BABs – taxable bonds to fund tax-exempt projects at taxable interest rates, with a 35% interest rate subsidy paid back to the local government issuer by the federal government. The 35% subsidy was meant to lower the taxable debt service to comparable debt service on a tax-exempt issue. In total, $3.351 billion of direct pay BABs are affected by the sequestration cuts.

In New Jersey, issuers of BABs are required by the Division of Local Government Services to budget the full taxable debt service payment on BABs in the budget, as if the local government would not receive any subsidy. However, the local government issuer is then permitted to anticipate the 35% subsidy payments as a revenue in the same year’s budget. As a result, New Jersey local governments will feel the effect of sequestration on the revenue side of the budget and not on the “outside-the-cap” debt service side.

Many BABs were issued with special redemption features that allow the issuer to refund its BABs in the event of an adverse tax action, such as a reduction in the subsidy. As interest rates generally are lower today than they were in 2009 and 2010, issuers of BABs should consult with their professionals to determine the viability of issuing traditional tax-exempt refunding bonds to refund BABs for a debt service savings. Perhaps the State Local Finance Board might even consider approving refundings of BABs that produce less than the standard 3% present value savings, particularly if the sequestration cuts to the subsidy end up being the first in a series.

Issuers of BABs will still be required to submit to the IRS their form 8038-CP 45 days prior to the interest payment date. The IRS will, temporarily, process the reduced subsidy payments by hand, but anticipates no delay in sending them out. Perhaps an indication of whether the sequestration cuts to BABs are here to stay, the IRS expects that it will have an automated system for processing the reduced payments by mid-April.

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