Build America Bonds have begun to reshape long-term taxable bond indexes that until now included little state and local government debt.

Part of the appeal of BABs — the taxable municipal bonds created under the American Recovery and Reinvestment Act last year — is that they provide long-duration exposure to a taxable bond market where corporations and sovereign governments are issuing mostly short-term paper.

With municipalities stepping in with more long-term taxable debt, the indexes tracking long-term taxable paper have begun to metamorphose to reflect the transition.

Of the 1,163 bonds in the Barclays Capital U.S. Long Credit Index, 150 are now municipal bonds, constituting 9.3% of the index’s market value. More than 1% of the index is debt issued by California, the biggest BABs issuer. The index also includes Illinois, the Bay Area Toll Authority, the New Jersey Economic Development Authority, and New York’s Metropolitan Transit Authority.

Ross Junge, who heads the U.S. portfolio management team at Aviva Investors, in April predicted by the end of this year BABs will make up as much as 16% of the index.

The inclusion of muni bonds in long-term taxable indexes is more than symbolic. The performance of many portfolios is evaluated based on a comparison with a benchmark index. Portfolio managers adhering to a long-term taxable index are now likely to buy municipal bonds to comply with their investment missions.

“Some investors are almost forced to purchase municipals to match the weighting of benchmark indices,” JPMorgan analysts Alex Roever and Chris Holmes wrote in a report this week.

The SPDR Barclays Long-Term Credit Bond Exchange-Traded Fund is a prime example.

The ETF’s goal is to replicate as closely as possible the returns on the Barclays long-term credit index.

The fund holds more than 5% of its $32.6 million portfolio in BABs, with California, Pennsylvania, the Los Angeles Unified School District, and Texas the biggest BAB holdings.

John Hawley, a portfolio manager at Aviva, said a portfolio manager managing to a long-term taxable index that now includes BABs has to make a decision: by not buying BABs he is implicitly taking a position against them.

“It does create demand because of that,” he said.

Aviva, which holds about $500 million of taxable municipals, manages money for insurance companies and pension plans, among other investors.

Peter Hayes, head of the municipal bonds group at BlackRock, said providing long duration to liability-driven investors, like pension funds, was probably the biggest spark to BAB sales initially.

Many pension funds and other ­institutional investors, like insurance companies, engage in what is known as liability-driven investing, or LDI. This ­investing style entails building a portfolio of assets that will help satisfy obligations as they come due.

For instance, imagine a pension fund knows it will have to pay a billion dollars to retirees in 30 years. The fund can buy a 30-year bond, the principal repayment of which will match the payout it will have to make.

LDI is a natural source of demand for long-term taxable bonds.

The twist is that outside of the ­municipal market, long-term debt is not easy to find.

The average maturity of a U.S. Treasury bond is less than five years, according to JPMorgan, while the debt of Japan and Germany matures in an average of less than 10 years.

Corporate borrowing has slowed. The supply of outstanding corporate debt was unchanged last year, according to the Federal Reserve.

Corporations in the second quarter of this year floated the smallest batch of new debt since the third quarter of 2008, according to Bloomberg LP.

And the corporate debt that has come to market has not been much help for long-focused investors. The average maturity for bonds issued by companies in the Standard & Poor’s 500 Index is less than 10 years, according to Bloomberg.

BABs offer municipalities the ability to sell taxable bonds, and collect a cash subsidy in lieu of the tax exemption on their debt.

Municipalities have sold $117.72 billion of BABs since the program’s inception. The average maturity of a BAB is more than 28 years, according to a Wells Fargo index tracking the sector.

That has helped fulfill the need for matching long-term liabilities with long-term assets.

“You have pension funds that need to offset their liabilities with similar-duration assets,” said Peter Demirali, a taxable municipal portfolio manager at Cumberland Advisors. “They’re looking at BABs to fill that need.”

The relationship is symbiotic.

While municipalities have provided the long-term exposure institutional investors need, the demand from these investors has helped lower borrowing costs for municipalities previously reliant almost exclusively on the tax-exempt market.

The after-subsidy cost of debt for a municipality issuing BABs is 3.87%, based on the average yield in the Wells Fargo index. The tax-exempt yield for 28-year municipals, by comparison, is 4.43%, according to Municipal Market Advisors.

“The abundant supply of long-duration taxable municipals has been a net positive for spreads, as duration-seeking investors like life insurance companies gravitate to munis in the face of declining duration supply across other asset classes,” Roever and Holmes wrote in their report.

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