In the fixed-income world, a private activity bond (PAB) is tax-exempt security issued by or on behalf of a local or state government. For bond investors, PABs can provide higher yields than other bonds due to their unique tax treatment.
A PAB is issued by local governments for the purpose of extending special financing benefits for qualified projects. In general, PABs finance projects for a private user, which means the local government doesn’t usually pledge its credit. In this way, they are used to attracting private investments for projects that have public or common utility.
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For municipal security to be considered a PAB, it must meet two conditions set out in Section 141 of the Internal Revenue Code.
- The first condition is that more than 10% of the proceeds must be used for a private business project and that at least 10% of the payments of the principal or interest comes from property used for private business use.
- Secondly, a PAB requires “the amount of proceeds of the issue used to make loans to non-governmental borrowers exceeds the lesser of 5 percent of the proceeds or $5 million, which is the “private loan financing test,” according to MSRB.
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Assets that fall under PAB are considered exempt facility bonds if they finance any type of facility used by private entities, including airports and other transportation-related facilities, local utilities and certain residential rental projects, among others.
Most private activity bonds qualify for an alternative minimum tax (AMT), which is an alternative method of deriving federal income tax. Since the Tax Reform Act of 1986, all private activity bonds are subject to AMT, except hospital and non-profit college bonds.
Under usual circumstances, private activity bonds provide higher yields due to their underlying tax treatment. It is estimated that investors get an additional 0.25% to 0.5% per year in additional income compared with similarly rated municipal bonds.
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Private activity bonds not only benefit private entities but the public as well, due to increased infrastructure spending. In an era of thin municipal budgets, the PAB structure incentivizes private equity investment in public projects. A notable example is American Water Works, which worked with the New Jersey Environmental Infrastructure Financing Program to expand water infrastructure following Superstorm Sandy.
Since PABs were first defined in 1968, the number of eligible private activities has more than doubled to 27 from 12. “Qualified private activities” refer to private activities that can be financed with tax-exempt bonds. The amount of tax-exempt bond financing is set by Congress through an annual state volume cap. This cap has also increased since new tax rules were implemented back in 1986. Of the 27 qualified private activities, 14 are subjected to the volume cap.
The most recent qualified private activity – the recovery zone facility bond – was established back in 2009.
Although tax-exemption is a contentious topic within the private activity bond world, the benefits outweigh the costs. That’s because private activities more than offset revenue loss and inefficient allocation of capital that is usually attributed to tax-exemptions.
The Bottom Line
Private activity bonds can be a major boon to municipalities – but only if the project succeeds. It’s clear by the underlying trend that PABs are being used more diligently to incentivize private participation in public works’ projects. Municipal bond investors should take heed of this trend.
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