The Build America Bonds (BABs) market has experienced a significant widening of spreads in recent months, primarily due to a wave of refinancing activities by issuers. Municipal bond strategists have noted that the BABs index option-adjusted spread has cheapened by 10bps compared to the ICE Broad Taxable Municipal Bond Index OAS. This trend has been attributed to the much-debated ERP refunding, where issuers have brought $4 billion of BABs to the market for refinancing purposes so far this year. The pace of refunding accelerated in April, with $2.4 billion issued in just the first two weeks of the month.
The increase in refunding activities has sparked controversy among investors, who question the legality of these transactions. Some investors have challenged the refunds, arguing that the repeated budget sequestration cuts do not qualify as an extraordinary event. This debate intensified after a court decision ruled that the sequestration cuts to the 35% interest subsidies constitute an extraordinary event, allowing issuers to call the debt. However, investors remain skeptical and have even threatened legal action against issuers replacing their debt.
Despite the ongoing legal challenges and investor concerns, some strategists recommend investing in certain types of direct-pay bonds. Barclays strategists, for example, suggest that even if the trend of calling BABs continues, there are direct-pay bonds worth buying due to their low risk of being called. They specifically point out that low-coupon BABs trading below par are attractive, as their holders will benefit if the bonds are called. However, investors should be cautious, as rising rates or bond prices jumping over par could increase the risk of calls and widen spreads.
Barclays highlights specific BABs, such as those issued by MEAG Power for its Vogtle nuclear plant, which are trading wider than T+100bp. The Vogtle 3 project is already operational, with Vogtle 4 expected to be completed soon. Additionally, Western Asset notes the potential value for investors willing to take on call risk in the BABs market. The firm acknowledges that attractive tax-exempt valuations are mainly limited to the AAA group, and issuance costs may mitigate some benefits.
The Bloomberg BABs Index has seen spreads widen to over 100bps from inside 90bps, signaling a shift in market dynamics. While the Bloomberg Taxable Municipal Index has outperformed the investment-grade corporate market, BABs have lagged within the taxable muni index. Despite concerns over call risk and widening spreads, some experts believe that ERP call activity may remain limited. The market continues to evolve as issuers maneuver through refinancing challenges, offering both risks and potential opportunities for investors.
The widening of spreads on Build America Bonds reflects the complexities and uncertainties in the current municipal bond market. Investors must carefully evaluate the evolving landscape and consider the recommendations of bond strategists before making investment decisions in this changing environment.