The taxable municipal market has many investment characteristics as its tax-exempt counterpart, and the credit and qualitative factors are nearly identical.

Taxable municipal bonds allow municipal issuers to fund all or portions of projects that are considered outside the parameters of qualified private activity bonds as defined under the Tax Reform Act of 1986 and, therefore, cannot be financed via traditional tax-exempt securities.

Its hybrid personality as a municipal bond with taxable income has made taxable municipal securities a sort of stepchild to both markets. Consequently, taxable municipals have typically offered investors the potential to earn above-average returns, especially on a risk-adjusted basis.

While most analysts consider the sector to have reached maturity, revolutionary change could be on the horizon as a result of provisions contained within the American Recovery and Reinvestment Act – specifically Build America Bonds (BAB).

Now that the U.S. Treasury has released final regulatory guidelines, the market is already experiencing an increase in this type of issuance. Some analysts predict that, viewed in the context of non-AMT (Alternative Minimum Tax) bonds, potential issuance of BAB could exceed $100 billion.

According to Kemp Lewis, Managing Director of Morgan Keegan’s Public Finance Department, “The U.S. government has given state and local governments the right to sell taxable debt in lieu of tax-exempt debt, and to receive a direct subsidy from the federal government equal to 35% of the interest cost of the taxable debt.”

“The BAB program is going to be very attractive to government issuers of tax-exempt debt due to significantly lower net borrowing costs,” he explains.

On average, BAB could offer issuers potential savings of roughly ten percent, according to some accounts.

Lower interest rates might encourage greater involvement in the taxable municipal market by a broader range of market participants, including pension funds, life insurance companies, and even property/casualty insurance companies.

Build America Bonds could become an attractive investment vehicle in the retail market, which typically shows strong demand for tax-exempt debt with early maturities (less than ten years). Most BAB will be in the longer-term maturity ranges; but because some expect that they will be comparable (or slightly better) in yield to similarly rated taxable instruments, they could offer greater appeal to retail investors. Additionally, these bonds, while subject to federal taxation, could be tax-exempt in some states of issuance, increasing their attractiveness for individual investors.

This article is an excerpt of “Taxable Municipal Bonds Prominence Continues to Grow,” a report recently released by the Trading Desk analysts at Morgan Keegan & Company, Inc. The views expressed are solely those of the author and not necessarily of

About the author:

Michael J. Ross is a Senior Vice President in the Municipal Credit and Strategies Group at Morgan Keegan & Company.

Mike has over twenty-five years of professional experience in fixed income research and credit analysis. Through the years, his research has appeared in several financial publications, including The Bond Buyer and Smith’s Research & Gradings.

He has worked in credit research and related fixed income departments of several broker/dealer and institutional investment firms. Prior to joining Morgan Keegan in April 2007, Mike teamed with other professionals to launch the Lord Abbett Municipal High Yield Fund. He was the Managing Director of Municipal Research for RBC Dain Rauscher for nine years before that.

Mike is a Chartered Financial Analyst (CFA).

Taxable Municipal Bonds in Perspective

The volume of taxable municipal bond issuance peaked at over $41.1 billion in 2003, but has flattened in recent years. In 2008, taxable municipal issuance totaled $25.9 billion. Total tax-exempt bond issuance was $341.8 billion.

Many of the larger taxable municipal bond offerings in recent years were issued by large municipalities to fund pension obligations. These bonds were issued as general obligation (G.O.) debt of the respective municipalities, with roughly half of volume insured.

While taxable municipal bonds are issued in other sectors as well, they are generally smaller in size than pension obligation bonds, and not secured by a G.O. pledge.

Since 1993, the Illinois Public Pension Fund, New Jersey Economic Authority, and the State of Connecticut, respectively, are the top three issuers of pension obligation bonds.