May 25, 2024

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MSRB: BABs redemptions could bring losses

3 min read
MSRB: BABs redemptions could bring losses

Investors should be aware of risks that Build America Bonds pose if called under an extraordinary redemption provision, as many of these could result in losses, especially if the bonds were purchased at a premium,the Municipal Securities Rulemaking Board warned Friday.

That comes amid expectations that issuers will redeem $20 to $30 billion in BABs this year under ERPs, the largest BAB ERP call year by a large margin, a strategist at Barclays said.

Mark Kim, chief executive officer of the MSRB.

“The MSRB is providing this information to make individual investors and market professionals aware of the developments and to help them make more informed investment decisions,” the MSRB said.

BABs were issued between April 2009 and December 2010 under the American Recovery and Reinvestment Act of 2009, with the government providing a subsidy of 35% for the interest paid on them.  The bonds were issued with the expectation that the 35% subsidy would not be subsequently reduced but has since been reduced many times through sequestration, with the current sequestration rate reduction sitting at 5.7%.

Most of the bonds issued with optional calls or make-whole calls also include ERPs, a mandatory or optional redemption triggered by the certain one-time or extraordinary events outlined in the bond indenture. Of the $180 billion total issued in BABs, there is currently around $110 billion of BABs with embedded ERP calls, a Barclays report said. 

As of February, $5.38 billion in ERP calls were announced for this year, a major jump from the $800 million called in all of 2023. Major issuers such as the Maryland State Transportation Authority, the Bay Area Toll Authority, the Los Angeles Unified School District and the University of California announced plans to call their BABs.

There is considerable controversy about the ERP redemptions, and at least one group of investors in the University of California bonds threatened legal action over it.

The MSRB notes the trend and wrote that the reduction in federal subsidy is a significant reason for the calls, as redemptions through ERPs are typically much less costly to issuers.

The board also notes that prior to these calls, many of the BABs were being traded on the secondary market at a significant premium to par and that the trade confirmation provided to an investor may not present the whole picture. 

“Due to restrictions related to an ERP, the ERP call is not used in the calculation of yield or dollar price,” the MSRB said. “This means yield to the ERP typically is not included in a customer’s confirmation or account statement, nor is it reflected on the EMMA website.”

“In looking at the trade history for BABs, the MSRB has seen a number of BABs trading in the secondary market at a significant premium to par, which could reflect the trading participants’ belief that an ERP is unlikely to be used to redeem those securities,” the MSRB said. “Investors should be aware of the risk that BABs could, depending on the specific terms of the bonds, be called pursuant to an ERP. This could result in a loss, particularly for investors who purchase the BABs at a premium.”