The widening spreads on Build America Bonds (BABs) in recent months have been attributed to a wave of refinancings, which have raised concerns about the legal ability of issuers to call the debt. According to municipal bond strategists, the BABs index option-adjust spread has cheapened by 10bps compared to the ICE Broad Taxable Municipal Bond Index OAS so far this year. This trend has been particularly noticeable in April, with $2.4 billion of BABs brought to market in just the first two weeks of the month. The overall impact on the BABs index has been a larger decline in index price compared to the broader TXMB index, signaling a shift in market dynamics for this type of debt.
The increase in refunding activity for BABs, driven by substantial savings for issuers who replace them with tax-exempt debt, has ignited controversy among investors. A court decision ruling that repeated budget sequestration cuts qualify as an “extraordinary” event allowing issuers to call the debt has further fueled the debate. Some investors have challenged these transactions, arguing that sequestration does not meet the criteria for an extraordinary event, and have even gone as far as threatening legal action against issuers who replace their debt. The uncertainty surrounding the legal implications of these refundings has created a sense of risk and unease in the market.
Despite the legal challenges and controversy surrounding BABs refundings, some strategists see value in certain types of direct-pay bonds that present limited call risk. Barclays strategists, for example, have identified low-coupon BABs trading below par as attractive investment opportunities with the potential for being called. However, they warn investors about the risks associated with bond prices jumping over par if rates rally, which could lead to widening spreads and increased call risk. The example of BABs issued for the Vogtle nuclear plant by MEAG Power highlights the potential for value in bonds trading wider than T+100bp.
The widening of spreads on BABs, as observed in the Bloomberg BABs Index, has signaled a shift in market sentiment towards these bonds. James G. Faunce of Penn Mutual Asset Management noted that BABs have become a notable laggard within the taxable muni index, with spreads now exceeding 100bps compared to inside 90bps in February. While some investors see potential value in taking on the call risk associated with BABs, others remain cautious due to the limited scope of ERP call activity and issuance costs that could detract from the positive benefits. Western Asset highlighted the attractive tax-exempt relative valuations in the AAA group but cautioned that call activity may remain restricted.
Overall, the widening spreads on BABs reflect a complex interplay of market dynamics, legal uncertainties, and investor sentiment. While some analysts see opportunities for value in select bonds with low call risk, others warn of the challenges and risks associated with the current environment. As the debate over the legal ability of issuers to call BABs continues, investors are advised to carefully weigh the potential rewards and pitfalls of investing in this segment of the municipal bond market.