A municipal bond is simply a bond that is issued by a municipality, country, local government or generally any government entity. These bonds are usually issued to raise funds to finance the capital expenditure of the issuing institution. Today, we will take a look at municipal bonds that issued by the US State Governments.

US State Government obligations are backed by the revenue generated by the States. No State Government has defaulted on its debt in the last 150 years. The implicit guarantee of the US Federal Government also strengthens the credit ratings assigned to these issuers. However, with the onset of the recession the yields of municipal bonds rose as State Governments experienced a contraction in revenues and a rise in expenses. The deteriorating fiscal position of many of these issuers has instilled some fear and trepidation in the market. Despite this, there is value in these instruments and the facts and fundamentals must be analysed to assess same.

One particular state deserves a closer look right now. California sustains investment grade credit ratings from S&P of A-. It is the world’s eighth largest economy and contributes roughly 13.5 per cent to US GDP. S&P cites revenue stabilisation, a relatively conservative debt burden, a deep and broad economy and Governmental reform as the primary factors underpinning this rating. These factors enhance the State’s ability to honour its debt. However, like many sovereign entities, the decline in economic activity placed significant pressure on the State’s finances. California, in particular, suffered sizable damage from the collapse of the property bubble that occurred in 2008 — 2009. These factors have increased uncertainty for investors and also contributed to a rise in yields. However the fundamentals of the economy such as its relative size and diversity remain strong, as does the State’s ability to repay its debt.

Build America bonds and foreign investors

Build America Bonds (BAB’s) are a type of municipal bond that were designed by the Obama administration to make funding more accessible and cheaper for Government entities during the credit crisis. This was achieved through an effective subsidy from the Federal Government. This subsidy could take one of two forms: A direct cash payment to the issuer, equivalent to 35 per cent of the interest cost or a tax credit of equal proportion to the bond holders. The issuer has the choice of how it would like the subsidy to be applied. However, the ultimate effect was the same; Government agencies were able to issue more attractive debt with higher coupons at a lower cost.

For example, if a State Government issues BAB’s at a coupon rate of 7.2 per cent, the issuer will receive a subsidy of 2.52 per cent annually from the US Treasury on each coupon date. The net interest cost to the issuer is 4.68 per cent, as opposed to 7.2 per cent without the help of the Federal Government.

BAB’s have made municipal bonds attractive to foreign investors. Generally municipal bonds are tax free to American residents, so they carry lower than normal coupons. As such, these are not particularly attractive to foreigners. However, build America bonds are taxable to US residents and therefore appeal primarily to foreign investors. It is therefore not surprising that the largest purchasers of BAB’s tend to be Foreign Central and Commercial Banks.

This programme expires on January 1st 2011. As a result, there has been a recent spike in the supply of new issues as US Government entities try to take advantage of this cheaper funding mechanism.

As a result of the increase in supply of BAB’s, yields on the instruments have risen markedly and prices have correspondingly fallen. This presents a window of opportunity for the buyer.

Marian Ross is a business development officer with Sterling Asset Management Ltd. Sterling provides medium to long term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor.

Sterling provides medium to long-term financial advice and instruments in US and other world market currencies to the corporate, individual and institutional investor. Visit our website at www.sterling.com.jm

Feedback: If you wish to have Sterling address your investment questions in upcoming articles, e-mail us at: info@sterlingasset.net.jm