Peter Demirali is a portfolio manager and heads Cumberland’s taxable fixed income area and is a long time veteran of taxable fixed income markets.  He is a member of Cumberland Advisor’s Management Committee.  His bio may be found at www.cumber.com.  Comments on this article may be directed to peter.demirali@cumber.com.

When Congress passed the stimulus bill in February, a provision in the act allowed the federal government to rebate 35% of the interest on municipal bonds that are federally taxable.  The intention of the provision was to broaden the market for municipal bonds and provide needed credit to state and local governments.  The credit crunch had severely hampered municipalities from getting access to the capital markets.  By providing this subsidy to state and local governments, the federal government is helping to lower the interest costs for issuers.  Indirectly, it has increased the credit quality of the bonds by providing this assistance.

Cumberland Advisors has been an active investor in taxable municipal bonds for over twenty years and welcomes this expansion of this asset class.  Taxable municipal bonds have always been a neglected fixed-income sector – neither fish nor fowl for most professional investors.  The reasons were (1) tax-exempt investors didn’t buy them because taxable municipal bonds were federally taxable and (2) taxable bond managers weren’t comfortable with small issues and unfamiliar names.  Our view was that illiquidity and different or strange names allowed for opportunity.  Historically, taxable municipal bonds carried the same or higher yields than similarly rated corporate bonds.  The default rates over the last 30 years were significantly lower for municipal issuers than for corporate debt issuers.  Given our bias to high quality and safety, we felt taxable munis were a good bet.  And now, with the federal rebate, this is the hottest sector in the fixed-income market.

Within the last week we have seen a number of issuers come to market.  The University of Virginia (rated AAA) and University of Minnesota each issued Build America bonds last week.  Both issues tightened significantly relative to Treasuries.  We have seen other very large issues of Build America Bonds by highly recognizable entities.  The New Jersey Turnpike Authority issued $1.375 billion in Build America Bonds this past Monday, at a spread to 30-year Treasuries of 370 basis points, to yield 7.414%.  On Thursday this bond traded at a spread of 315 basis points, almost six points higher in price!  During this same period, 30-year Treasuries declined two points in price.  This is a great total return for investors who bought this issue.  Cumberland Advisors was fortunate to get one-tenth of what we asked for in our allotment.  Also, the State of California issued $4 billion in Build America Bonds on Wednesday.  Spreads tightened 25-30 basis points the very next day.

Clearly, this is an exciting development in the public finance arena.  We expect many more large issuers will tap this market over the coming quarters.  The financial incentive that reduces a municipal issuer’s capital costs by issuing these bonds is compelling.  Broadening the universe of investors will also provide issuers greater financial flexibility.  The result will be reduced issuance of tax-free bonds and ultimately lower yields on tax-free debt.