A federal subsidy may change the muni bond market for good

The Economist reports:

This year’s economic-stimulus legislation allowed states and local governments to issue taxable bonds and receive a federal subsidy equal to 35% of the bond’s interest. These “Build America Bonds” have been a hit, especially with big, weakened borrowers like California and New York. Some $58 billion have been issued so far, equal to 15% of this year’s municipal issuance, according to Thomson Reuters. Analysts at JPMorgan reckon that issuance could reach $110 billion next year.

The direct subsidy is far more efficient than the federal tax break on interest. The tax exemption often costs the Treasury more than the borrowers save on interest payments. It also makes the market smaller and less liquid by excluding investors (such as foreigners or pension funds) who do not pay federal tax anyway. And the exemption mainly affects wealthy taxpayers, who are unsure of its benefit because of a constantly changing tax code, says Howard Simons of Bianco Research.

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