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1 PRAMERICA FIXED INCOME Build America Bonds: High Quality in Long Maturities March 2010 Build America Bonds One Year Later: High Quality in Long Maturities April 2010 Susan M. Courtney Managing Director and Head of Municipal Bond Team Pramerica Fixed Income After the impressive performance from the fixed income market in 2009, a common concern among many plan sponsors is how to continue to generate yield and total return potential in their fixed income allocations, now that spreads are at narrower levels. One part of the solution may be an allocation to Build America Bonds (BABs), a fairly new type of taxable municipal bond authorized by the US Government as part of the economic stimulus package in February Build America Bonds have many of the same qualities as investment grade corporate bonds, but often trade at more generous spreads over US Treasuries. For these reasons, they may be a good diversifier to existing corporate credit risk in Core or Core Plus, Corporate, or Long Duration portfolios. The Origin of Build America Bonds The $2.8 trillion municipal market, like other credit-related fixed income markets, endured a highly dysfunctional period during the fourth quarter of 2008 following the bankruptcy of Lehman Brothers. The flight to US Treasuries during that time, at the expense of virtually all securities carrying any kind of credit risk, hurt the US municipal market as well. Yields on tax-exempt municipal bonds, which typically trade well below yields on taxable US Treasury bonds of similar durations, surged above US Treasury yields during the crisis. The disruption was further exacerbated by the demise of the leading municipal bond insurers, which collectively had insured approximately half of all new municipal issuance. Municipal Bond Perspectives For more information contact: Peter Lindqvist Managing Director Pramerica Investment Management Limited Grand Buildings, 1-3 Strand Trafalgar Square London. WC2N 5HR Telephone: +44 (0) Switchboard: +44 (0) Fax: +44 (0) peter.lindqvist@pramericafi.com The graph below shows the five-year history of the 30-year municipal/us Treasury ratio, which is the 30-year municipal yield as a percentage of the 30-year US Treasury yield. The most recent five-year average for this ratio has been 100%. Longer term, it has been closer to 95%. In December 2008, the ratio exceeded 200%. At the ratio s peak, the 30-year AAA municipal yield was 5.31% while the 30-year Treasury was at 2.52%. Investors were demanding more than twice as much tax-exempt yield to own a high quality municipal bond over a US Treasury bond. Figure 1 30-Year Municipal/Treasury Ratio Over Past Five Years March 31, 2005 March 31, % 190% 170% 150% 130% 110% 90% 70% 50% 30 Yr Muni/Treasury Average Rich Cheap Source of data: Municipal Market Data, Bloomberg. As of March 31, 2010.

2 Not surprisingly, municipalities had an extremely difficult time accessing the capital markets to issue new bonds in this environment: new issue municipal volume in the fourth quarter of 2008 declined 24% over the prior quarter. Given the necessity of such issuance by municipalities, cities, and states to fund essential and ongoing services such as road improvements, school construction, and water and sewer projects, the sudden inability to issue new municipal bonds posed a real threat to the US economy. Out of this dysfunction a new sector of the municipal market was born: Build America Bonds. The Build America Bonds* program was created by the US Government as part of the massive economic stimulus package enacted in February The goal of the Build America Bonds program was to help municipal issuers more efficiently access the capital markets by broadening the attractiveness of municipal bonds to more investors. Historically, of course, municipal bond buyers have been almost exclusively individual retail investors seeking tax-exempt interest income. Institutions such as pension funds, life insurance companies, and non-us investors derived no benefit from tax-exempt interest income and thus had no reason to invest in an asset class that offered yields well below comparable taxable bonds. What are Build America Bonds? The Build America Bonds program changes this dynamic. Under the Build America Bonds program, certain municipalities can issue taxable bonds at prevailing market-based taxable yields. The municipality receives a direct subsidy from the federal government equal to 35% of the interest payments on those bonds, so its net interest expense declines post-subsidy. There is no cap on the amount of Build America Bonds that a municipality can issue, but the bond proceeds must be used for capital expenditures, as opposed to refunding higher coupon outstanding debt or raising cash to meet general operating expenses. These higher taxable yields make Build America Bonds an attractive component of the universe of fixed income securities now available to institutional investors. Approximately 44% of the Build America Bonds issued to date have been general obligation (GO) credits. That means the state or locality issuing the bond has the power to impose or raise taxes to cover the interest and principal payments on the debt, despite how politically unpopular that may be. This ability to tax provides a measure of safety to general obligation bonds. Still, these credits must be carefully analyzed. Factors such as the income levels and the economic base of the population, as well as the debt levels and financial and budgetary management practices of the issuer, are a key component of the credit analysis of general obligation bonds. The remainder of Build America Bonds the other 56% issued to date have largely been revenue bonds, such as transportation, water, sewer, power, and dedicated tax bonds. In contrast to general obligation bonds, a municipal entity issuing a revenue bond must rely solely on the revenue generated from the system or dedicated tax to make debt service payments on the bond. For this reason, some investors have a preference for general obligation bonds over revenue bonds. However, we believe there is value to be found in revenue bonds as well as general obligation credits. Many revenue bond issuers are the sole providers of essential services such as water, sewer, and power in a given region, and have independent rate-setting ability. Because of the necessity of these services and the ability to set rates, the providers of these services generally enjoy steady income from the users of the services, and a customer base usually diversified across both residential and commercial customers. In addition to the dedicated revenue stream securing the bonds, further support is provided by various covenants in the bond indentures. Finally, because they often provide essential services, revenue bond issuers (unlike issuers of general obligation bonds) can generally operate away from the often-harsh political environment of state and local governments during difficult times. *This paper addresses direct subsidy Build America Bonds vs. tax-credit Build America Bonds. 2

3 Build America Bonds Are Becoming Increasingly Important to the US Fixed Income Market Build America Bonds are becoming increasingly important to the US fixed income market, particularly in the long duration segment. Taxable municipal bonds have been around for years, with municipal entities issuing them for financings not intended for general public benefit. They have been included in the Barclays US Aggregate Index since 2003, when several states issued pension obligation bonds. At that point, (October 1, 2003) taxable municipal bonds comprised only 0.20% of the Barclays US Aggregate Index and only 0.72% of the Barclays US Credit Index. The Build America Bond program has spurred rapid growth in the taxable municipal universe. By late April 2010, taxable municipal bonds (Build America Bonds, as well as other taxable municipal bonds) comprised 0.55% of the Barclays US Aggregate Index and 2.5% of the Barclays US Credit Index. It is estimated that by the end of 2010, there will be over $200 billion in Build America Bonds outstanding. Taxable municipal bonds, which include Build America Bonds, are estimated to grow to 4.1% of the US Credit Index by the end of this year. (Estimates are not guaranteed and actual results may vary) In fact, Build America Bonds have become so influential to the US fixed income market that the major index providers have begun introducing indices comprised exclusively of Build America Bonds. The Barclays Build America Bonds Index, for example, was introduced in October At the end of April 2010, it contained more than 80 issues. Its duration was 12.5 years, with an average credit quality of Aa3/A1 (Moody s). Similar to other credits entering Barclays credit-related indices, Build America Bonds must have at least one year to maturity and an initial issue size of $250 million to be index-eligible. The following table summarizes the characteristics of the Barclays BAB Index along with other indices: Table 1 Characteristics of Barclays BAB Index vs. US Credit Indices BAB Index Muni-Taxable US Credit US Long Credit Market Value ($billions) $48 $82 $3,261 $802 Average Coupon (%) Average Yield (%) Average Maturity (yrs) 30 yrs 24 yrs 10 yrs 24 yrs Duration (yrs) 12.5 yrs 10.7 yrs 6.3 yrs 12.1 yrs Ratings Aa3/A1 As3/A1 A2/A3 A2/A3 OAS vs Treasuries (bps) Source of data: Barclays Capital. As of April 23, Biggest Impact Seen in Long Duration Segment of Market The most influential impact of Build America Bonds is seen in the long duration segment of the fixed income market. Taxable municipal bonds comprised 2.91% of the Barclays Long US Credit Index in 2003 and today comprise 8.9% of this Index (As of March 31, 2010). They are estimated to grow to 16.7% of the Barclays Long US Credit Index by the end of The Long US Credit Index is being used increasingly by corporate pension plans to better match their assets with their liabilities. 3

4 Why Build America Bonds Are Attractive to Issuers Build America Bonds provide two primary advantages to issuers: 1) Economic Advantage The first advantage of Build America Bonds to an issuer is an economic one. Simply put, Build America Bonds present municipalities with another financing alternative. And, like most things, the introduction of alternatives often leads to more competitive results. Depending on the purpose of the financing, municipal issuers can now price their new issue as either tax-exempt or taxable, choosing the most economically advantageous path for the given issue. Factors such as the prevailing term structure of interest rates at time of issuance, maturity of the issue, and demand factors influencing tax-exempt yields all help determine the economically superior option at the given time. Part of the issuer s decision-making criteria will also include flexibility regarding desired structural features such as call provisions. Municipal issuers may have to forgo certain call options to appeal to investors accustomed to buying non-callable corporate bonds. Because Build America Bonds often provide cheaper financing for the issuer for the life of the outstanding debt, it has made longer-dated issuance particularly attractive. Through the end of April 2010, 77% of Index-eligible Build America Bond issuance has been 25 years and longer. This is a noteworthy divergence from the US investment grade corporate bond market, where, despite record new issuance in 2009, the majority of the supply was concentrated in maturities of 10 years or less. To date, Build America Bond issuance has generated significant savings for states and local municipalities relative to the cost of issuing comparable maturity tax-exempt debt. The table below illustrates this in detail: Issuer Los Angeles Unified School District Table 2 Savings Realized By Issuing 30-Year BABs Instead of Similar Maturity Tax-Exempt Bonds BAB Coupon Maturity Ratings Moody s/ S&P Taxable BAB Yield Post-Subsidy Cost To Issuer for BAB 1 Approx Tax- Exempt Cost Net Savings From BAB 6.758% 2034 Aa3/AA- 6.76% % 4.84% bps NYC Water 6.01% 2042 Aa2/AA+ 6.01% % 4.45% bps University of MA Building Authority 6.573% 2039 Aa3/A+ 6.57% % 4.73% bps State of California GO 7.625% 2040 A1/A- 7.48% % 5.65% bps Source: Pramerica Fixed Income, Bloomberg. 1 Based on 35% subsidy. 2 Based on new issue pricing of tax-exempt and BAB deals in mid-february Based on new issue BAB deal from March Based on new issue pricing of tax-exempt and BAB deals in mid-october Based on new issue pricing of tax-exempt and BAB deals in March ) Access Advantage The second important advantage Build America Bonds provide municipal issuers is access to a new and much broader investor base. Large states and municipalities with significant financing needs are extremely sensitive to financing costs and liquidity. Accordingly, they require an ongoing and diverse source of buyers to prevent investor saturation and to keep financing costs competitive. 4

5 The State of California, for example, is the largest issuer in the tax-exempt municipal market today, representing approximately 4.5% of the Barclays Municipal Bond Index. California, currently rated A1/A-/A- by the three major credit rating agencies, has issued more than $10 billion in BABs since the Build America Bond program launched in April It is expected to continue to issue frequently given its significant financing needs. Why Build America Bonds Are Attractive to Investors The Build America Bonds program provides a clear incentive to municipal issuers, but what about investors? There are a number of benefits to investors: 1) High Quality Headlines on state budget deficits notwithstanding, most municipal issuers are high quality credits. A default study by Moody s dated February 2010 ( US Municipal Bond Defaults and Recoveries, ) notes that more than 85% of municipal issuers are currently rated single A or higher. This is in contrast to the global investment grade corporate market, where only 37% of issuers are rated single A or higher. The higher quality has historically translated into lower defaults and higher recoveries for municipal bonds. The Moody s default study notes that the 10-year cumulative default rate for investment grade municipal bonds was a minor 0.06%. In contrast, the 10-year cumulative default rate for investment grade corporate bonds during the same period was 2.50%. Not only have municipal bond default rates been lower than those of corporate bonds, but their recoveries after default have been higher as well. The Moody s study notes that the average recovery rate on defaulted municipal bonds during the period was 67% of par, compared to 37.5% of par for defaulted corporate bonds. For fixed income allocations that are heavily exposed to investment grade corporate credit, Build America Bonds can potentially provide another high quality credit alternative, further diversifying portfolios. 2) Plentiful Supply in Long Maturities Build America Bonds tend to be issued with long maturities. Of the $82.9 billion in new taxable municipal bonds issued in 2009, $64.8 billion, or 78%, were in maturities 13 years or longer. This is a very different profile than the investment grade corporate bond market, where approximately 10% of new issuance in 2009 was in maturities 13 years or longer. (Source: Barclays Capital.) Of course, overall issuance volume in the US investment grade corporate bond market remains significantly higher than in the taxable municipal market. This predominance of long maturities is reflected in the duration of the Barclays Build America Bonds Index. In April of this year, that Index s duration stood at 12.5 years, a full six years longer than the 6.3 year duration of the Barclays US Credit Index. We cannot underestimate the importance of this long maturity focus in the current environment. As has been welldocumented, demand for high quality, long duration corporate bonds has soared since the advent of the Pension Protection Act. It is becoming increasingly challenging to purchase long duration corporate bonds in size at attractive spreads. 5

6 Figure New Issuance, By Maturity Taxable Municipals and Investment Grade Corporates 1-12 Yrs 13+ Yrs 2.3% Investment Grade Corp 46.3% Taxable Municipals 53.7% 97.7% Excludes Government-guaranteed debt. Source of data: Barclays Capital. As of December 31, ) Sufficient Market Liquidity Trading liquidity was far from assured when the first Build America Bond was issued in April The program was new and an active secondary market had yet to be established. Institutional buyers were unfamiliar with the fledgling Build America Bond program and indeed with municipal bonds in general. To attract investor interest, the early Build America Bond deals were priced at significant concessions to comparably-rated corporate bonds. These early concessions were so attractive that most early deals were oversubscribed. One of the earliest deals, for example, was the $1.4 billion New Jersey Turnpike Authority deal, rated A3/A+/A, which was priced at issue in April 2009 at +370 bps spread to the 30-year Treasury. Since then, through late April 2010, spreads have tightened approximately 235 bps for this credit. By comparison, an indicative spread for a mid-single A corporate industrial bond at that time was approximately +235 bps to the 30- year Treasury, and has since tightened 145 bps. Thousands of municipal entities have subsequently issued Build America Bonds, with close to $100 billion in total issuance through late April The volume of issuance has added to the depth of the taxable municipal market, leading to tighter concessions and improved liquidity. Not surprisingly, liquidity is highest in the larger, index-eligible deals, although we believe value can be found in certain non-index eligible deals, provided careful research is conducted. We have also observed that the depth of the investor base has broadened with the passage of time, with an increasing number of investors now participating in the larger Build America Bond deals. The Federal Reserve Board s Flow of Funds report sheds light on the holders of municipal debt. Between 2008 and 2009, foreign investors increased their holdings of municipal debt to $60.6 billion (from roughly $41 billion), presumably from participation in Build America Bond deals. (Report released in March 2010.) In fact, approximately 30% of a recent California G.O. Build America Bond deal was purchased by non-us investors. 4) Good Total Return Opportunities, Particularly in the Long Duration Segment Despite the spread tightening in 2009, Build America Bonds generally remain cheaper than comparably-rated corporate industrial bonds. Perhaps the biggest reason is the simplest one: familiarity. Build America Bonds are only a year old, and most institutions are still more comfortable investing in corporate bonds. In addition, despite historically low default rates and generally higher quality ratings, current fiscal pressures among state and local 6

7 governments cannot be ignored. Build America Bond issues need to be carefully researched, and not all institutions have been able to commit the resources required to analyze these credits. Finally, while liquidity in the Build America Bond market has clearly improved, it remains less liquid than the larger and more established corporate bond market. The table below illustrates the spread differentials more clearly: Table 3 Good Total Return Opportunities Issuer Deal Size ($mm) Ratings Moody s/s&p/ Fitch Spread to 30-Yr Treasury* (bps) Chicago Metropolitan Water $600 Aaa/AAA/AAA +81 University of California $758 Aa1/AA/NR +125 Missouri Highway $280 Aa1/AA+/AA- +90 New York City Water Authority $375 Aa2/AA+/AA New York City GO $800 Aa2/AA/AA Bay Area Toll Authority $1,300 Aa3/AA/AA Los Angeles Unified School District GO $1,250 Aa2/AA-/NR Illinois Highway $280 Aa3/AA-/AA NJ Turnpike $1,370 A3/A+/A +135 North Texas Tollway $825 A2/A-/NR +158 State of California GO $1,250 A1/A-/A Comparative Trading Spreads for Corporate Industrial Credits* AA rated = T + 73 A rated = T + 90 A- rated = T BBB rated = T Source: Pramerica Fixed Income. Shown for illustrative purposes only. Estimates are not guaranteed and actual results may vary. * Indicative spreads are as of April 26, 2010 and represent estimates only. Despite Low Defaults Historically, are Municipal Bonds Safe Today? The deep US economic recession we are emerging from has certainly had a negative impact on municipalities across the country. In general, most states and localities have had to cut expenditures significantly and implement revenue-raising actions where possible to balance their budgets. While the states received aid from the US government as part of the economic stimulus package enacted last year, this aid is scheduled to expire at the end of In the meantime, many states are still struggling to close budget gaps. We believe the majority of states and municipalities will continue to make the difficult, unpopular decisions required to balance their budgets. We also expect that municipalities that avoid taking the required and responsible actions to balance their budgets will see their debt ratings downgraded by the credit rating agencies. As has been widely noted in headlines across the country, there are increasing concerns questioning the ability of certain municipal issuers to repay their debt. Despite these recognized challenges, the majority of investment grade municipal issuers are not high default risks, in our view. Discussions surrounding rising defaults in the US municipal market are centered primarily around high yield municipal credits, which, like high yield corporate bonds, are rated below the BBB rating category. The Barclays Municipal Bond Index had a market value of $1.23 trillion on March 31, 2010, while the Barclays Municipal High Yield Index had a market value of $54.5 billion. If we use these indices as proxies for the overall municipal market, we see that approximately 96% of the municipal market is considered investment grade. Certain municipal high yield sectors that have experienced increased levels of distress in recent years have been special assessment district deals (which are directly supported by real estate development projects) and senior living facilities. Outlook for Build America Bonds Under current legislation, municipal issuers have the ability to issue Build America Bonds through the end of As part of President Obama s 2011 budget proposal, he has recommended that the program be made 7

8 permanent, although at a reduced subsidy of 28% instead of the current 35%. The proposal also calls for expansion of the program to include other municipal issuers as well as broaden the purpose beyond capital expenditures. Highlighting the success and importance of the program, the House Ways and Means Committee subsequently passed a bill that includes a provision to extend the Build America Bonds program a few years, gradually reducing the subsidy from 35% to 30% by This bill is currently under consideration in the Senate. While a final decision on the future of the program is still months away, we believe it highly likely that the Build America Bond program will be either extended or made permanent later this year. Such moves will further improve the liquidity of Build America Bonds, as the investor base expands to include participants who may not have been willing to dedicate resources to a program scheduled to end in Until a final decision is made regarding the future of the program, we believe municipal entities will continue to take advantage of the 35% federal subsidy by issuing Build America Bonds, especially on the long end, in increasing numbers. In fact, as noted earlier, it is estimated that by the end of 2010 there will be over $200 billion in Build America Bonds outstanding. Interestingly, Moody s and Fitch recently began the process of recalibrating their municipal rating scales. The primary driver for this action, according to Moody's, is the market's desire for closer ratings comparability between municipal and corporate bonds, particularly now that Build America Bonds have expanded the universe of municipal bond buyers. This recalibration will result in higher published credit ratings for both the outstanding and future debt issuance of several types of municipal issuers. Conclusion Build America Bonds offer fixed income investors high quality, relatively high yields, and long-dated maturities. Additionally, Build America Bonds also offer valuable sector and credit diversification from an asset class municipal bonds that has had historically low default rates. As such, we believe high quality, index-eligible Build America Bonds represent excellent value for institutions seeking exposure to long duration assets while also benefiting from credit and sector diversification. Institutions gain access to an asset class of high quality securities with high relative yields and long-term maturities, at attractive valuations. For these reasons, we have tactically added select Build America Bonds to some of our insurance, corporate, asset-liability, Core, and Core Plus mandates. 8

9 NOTES Copyright Pramerica Investment Management Unless otherwise indicated, Pramerica holds the copyright to the content of the article. Pramerica Investment Management is a trading name of Prudential Investment Management, Inc., the principal asset management business of Prudential Financial, Inc. ( Pramerica Financial ). Pramerica Investment Management is an indirect subsidiary of Pramerica Financial, a company incorporated and with its principal place of business in the United States. Pramerica Investment Management is an investment adviser registered with the U.S. Securities and Exchange Commission. Pramerica Fixed Income is Pramerica Investment Management's largest public fixed income asset management unit. Prudential Financial, Inc. is not affiliated in any manner with Prudential plc, a company incorporated in the United Kingdom. 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