ICBA Securities: Muni Investment Options May Leave the Table

All Aboard!

Municipal investment options may leave the station

There are few tangible benefits which bankers have realized from the financial services meltdown in the past three years.  One of them is the vast improvement in investment options for municipal securities, primarily as the result of (at the time) little-noticed segments of the main stimulus bill, the ARRA.  As of this writing, all of those provisions are scheduled to disappear over the horizon at the end of 2010.

It is correct that high-performing portfolios have consistently had a significant portion of their investments allocated to municipal securities.  Our bond accounting customer population, which is currently around 575 banks, shows that the top quartile by yield has around 32 percent of its bonds in munis, compared to about 7 percent for the bottom quartile.

This doesn’t mean that all of these options are destined for the boneyard, though I would also opine that it’s unlikely all will survive into 2011 and beyond.  Still, the yield, diversification, and strategic benefits they provide deserve another recitation.

Two Percent Rule

Buried in the minutiae of the ARRA is a provision that allows a bank to purchase up to two percent of its assets in general market munis, and still receive favorable TEFRA treatment.  In essence, the investor gets to treat the “2% bond” as if it were bank-qualified.  The requirements are that the issues are dated 2009 or 2010, and that they are “new money.”  This means that the issuance cannot be for refinancing outstanding debt.

This creates other potential positives, including picking up CRA credits.  Most CRA-qualifying bonds are in the form of general market issues, mainly due to the size restraints.  So there are several benefits that could be derived from careful picking and choosing.  This obviously requires your broker to be on top of the details, so be sure to get fully satisfied that all the facts are hammered out before agreeing to purchase a 2% bond.

AMT-Free

For banks that are at or near the Alternative Minimum Tax (AMT) threshold, we advise consideration of 2009 and 2010 issues, either bank-qualified or general market.  These issues will be AMT-free for the life of the bonds even if the provision sunsets at the end of the year, according to current law.  A restriction for AMT-free treatment is that the proceeds must be either for new money, or to refinance outstanding debt that was originally issued after 12/31/03.

Be careful about the AMT-free bonds that you are considering, and put the onus on your broker to document a given offering’s qualifications.  I should also be on record as saying your tax accountant needs to be involved in this process to quantify the AMT exposure.  And, in future years there may be an boost to the market value of these 2009-10 issues if there are no more being printed—a simple case of demand outstripping supply.

BABs

A very visible aspect of the ARRA is the creation of the Build America Bond program.  These are taxable munis, not guaranteed by Uncle Sam, but whose cost is partly subsidized by him.  Investors pay taxes on the yield received, and the issuer gets a rebate of 35 percent of the cost.  So, to an issuer the cost is roughly the same as if it were tax-free debt.  Over 25 percent of all munis issued in 2010 will be of the BAB variety.

Since BABs are taxable they are potentially suitable for many investors, including those that pay no Federal taxes.  If your bank will have little or no earnings in the near future, BABs may be a great way to invest in the muni sector.  Even if your bank is fully taxable, and I hope it is, bonds are available in virtually every corner of the country, and in a wide variety of block sizes and maturities.  They also are generally issued for the purpose of infrastructure, so they shouldn’t have much exposure to private-activity mischief.

Last Call

This column just scratches the surface of the rapidly-evolving municipal bond market.  Other elements not discussed here include the possible reversion to $10 million for the maximum annual BQ issue size, or the prospect of the BABs subsidy shrinking to 28 percent or less.

Be sure to keep in touch with your broker about these and other elements of the municipal securities market.  Let’s hope these opportunities in late 2010 will enable banks to take the muni train to more profitable destinations.

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ICBA Securities can consult with you concerning a desirable mix of municipal investments.  Contact your ICBA Securities sales rep or visit www.icbasecurities.com for recent Strategic Insights on municipals.

Jim Reber is president/CEO of ICBA Securities and can be reached at 800-422-6442 or jreber@icbasecurities.com.