After the presidential elections, two main questions have emerged: Can Private Activity Bonds (PABs) be the solution for America’s “crumbling” infrastructure? And how can an average investor capitalize on the Presidential election promises around infrastructure boost?
In this article, we attempt to answer these questions.
An Introduction to PABs
In the state and local governments, municipal debt covers a wide array of financing tools for funding various projects. PABs are one of those tools, and can be used by single or multiple private entities in conjunction with the local or state governments. PABs are essentially a sub-segment of the broad muni universe.
However, unlike general obligation debt, where a city’s credit worthiness and tax revenues provide the backing, PABs’ revenue streams come directly from the projects and are backed solely by the private entity’s credit rating. This poses an increased risk for potential investors, as PABs can be viewed as tax-exempt corporate bonds. As an example, let’s look at a general obligation bond (view the CUSIP here) and a PAB (view the CUSIP here) with similar maturities. Despite the similar maturities, the PAB offers a higher coupon to compensate for the risk factor attached to the private entity’s debt repayment capacity.
In recent years, private sector involvement in meeting infrastructure needs has been drastically high for local and state governments. This makes PABs an essential part of the public-private partnership (PPP) ecosystem. PPPs have been playing a crucial role in the development of sectors like water and wastewater projects, housing (local- and state-level affordable housing, senior and military), transportation, government buildings, education, healthcare and energy (including production and distribution of energy, even renewable energy projects). To explore muni bond trades, including trades of PABs, visit our Market Activity section.
At present, there are propositions to include sectors like public education institutions and government infrastructures under the umbrella of PPPs, which would potentially increase the scope for PABs.
State-Level Restrictions on PABs
In PAB issuances, every state is bound by volume caps on how much low-cost, federal-tax-free private capital can be issued. In 2015, the volume cap for each state was equal to the greater of $100 per capita or $301.52 million; in 2016, these caps were increased by 0.76% nationally. Each state can allocate its volume cap among its municipalities, agencies or different statewide projects. The cap that’s not used can be carried forward for the next three years by the state.
Currently, some government-owned facilities like ports, airports, housing, high-speed intercity rails and solid waste disposal sites are exempt from the annual state volume caps. There have also been legislative propositions in 2016 that are pushing to lift the volume cap for water and wastewater projects, thus providing an opportunity for local governments to access low-cost private capital for multi-year water infrastructure projects.
Currently Active Sectors Relying on PABs
Let’s take a look at some prominent issues in the public infrastructure spaces that are currently issuing PABs.
One of the prime examples of PPP is the new capital issuance of PABs in southern California by the city of Long Beach for major improvements at the Long Beach airport. This venture was taken in conjunction with the local government and there were two issues (private and governmental) totaling over $61 million.
In the transportation sector in Denver, Colorado, the formation of a PPP between the Regional Transportation District and Denver Trans Partners (a private entity) led to the successful issuance of PABs, totaling $396 million for a rail lines expansion project.
AMT Exemption Provision for PABs
The growth of PABs was bolstered under the American Recovery and Reinvestment Act (ARRA), wherein alternate minimum tax (AMT) was exempted in 2009 and 2010. With the pullback of the exemption, PAB issuance declined after 2010.
However, one of the major highlights in the PAB space in 2015 was the bringing back of the AMT exemption provision. This brought a sigh of relief and makes this investment more appealing and lucrative. It also cuts down the cost of issuance for issuers to raise the capital at favorable yields, because investors are willing to forego some yield for AMT exemption. To learn more about how AMT works in the context of muni bonds, read our article on what investors need to know.
PABs in the Changing US Economic and Political Climate
According to the Bond Buyer, PAB issuance was up by over 11% in 2015 from 2014 ($12.95 billion in 2015 versus $11.61 billion in 2014). The data represents organic growth in the US that also correlates with the growth in job numbers.
As the US economy shows healthy growth in multiple sectors, it is evident that the local (especially in bigger cities) and state governments would be eager to plan for the future. These plans would account for population growth, traffic congestions, and staying relevant with the rest of the world on transportation technology. Where private entities are eager to capitalize on this infrastructure push, local and state governments also understand the importance of PPPs to create a growth environment. This can expand the overall scope of PABs.
Key Considerations for Investors
When looking at PABs, investment decisions should be made in the context of:
- The new government’s policy outlook to provide an infrastructure push for essential utilities, i.e., schools, affordable housing, transportation, water and wastewater.
- Lifting or raising the state volume caps for water and wastewater infrastructure projects.
- Government’s intention to continue with the AMT exemption provision.
- The Fed’s decision to raise short-term interest rates in the coming months.
Of these, the key variable is the rising treasury yield environment. Most investors are aware of the inverse correlation between rising interest rates and bond valuations, i.e., when rates start to rise, values of bonds, especially those with longer durations, will always decline. Although infrastructure spending is expected to go up in the US following the election, a rising rate environment could be a concern. On the brighter side, if you are an investor with a long time horizon and contentious attitude with the coupon payments on PABs, then you should hold the debt instrument until maturity and enjoy the coupon payments irrespective of what the interest rates do.
Nevertheless, before considering your investment into any debt instrument it is imperative to familiarize yourself with the revenue streams backing the debt, the official statement of the issuance, the rate environment and your own investment objectives. Check out our Municipal Bonds Glossary for a quick overview of the terminology used in the municipal bond market.
PABs provide investors with the opportunity to cash in as political focus shifts to creating jobs through building and revamping the national infrastructure. While the municipal debt sector is under much scrutiny from an investor standpoint due to rising interest rates, PABs may provide attractive returns for many investors. Moreover, the expansion of PPPs and the return of AMT exemptions will foster an organic economic growth at both local and state levels.
To stay up to date with the basic concepts of municipal bonds, visit our Education section.