What are Build America Bonds? The Build America Bond (BAB) program was created as part of the American Recovery and Reinvestment Act of 2009 (ARRA). The program allows state and local governments to issue taxable bonds and receive either a 35% subsidy back from the Federal government or issue tax credits to investors. The subsidy offsets a portion of the municipality s borrowing cost. The program was launched in April 2009 and resulted in approximately $62 billion of issuance in 2009. The BAB program is not a guarantee program. BABs are not guaranteed by the Federal government. The program is designed to lower funding costs for states and other municipal bond issuers. As originally written into the Recovery Act, proceeds from BAB deals are intended to fund capital expenditures, must be new money issues and cannot be used to refinance existing debt. There are two ways in which issuers can issue BABs: Direct Payment: The 35% government subsidy is paid directly to the issuer. All of the BAB supply has come in the form of direct payment issues. Tax Credit: The 35% subsidy is paid to the investors in the form of a Federal tax credit. No tax credit BABs have been issued. As illustrated in Chart 1, taxable BABs can offer a municipal issuer a significant advantage versus traditional taxexempt municipal bonds. Chart 1 Issuer: University of California (Aa1/AA) Issue Date: August 2009 Maturity Date: 2031 BAB Yield = Treasury (4.27%) + 195 bps spread = 6.22% U. Cal receives a 35% subsidy. Net interest payment = 6.22% x.65 = 4.04% Comparable tax-exempt bonds were issued at 4.93% (+44 bps to AAA) Savings to issuer: 4.93% - 4.04% = 0.89% annually Source: Bloomberg, GW&K trading desk Nature of BAB Issuance The slope of the municipal curve is generally steeper than the taxable curve, meaning the best economics for issuing BABs tend to be at the long-end. Long-term tax-exempt bonds tend to be more expensive for issuers relative to other parts of the curve as illustrated in Chart 2. As Chart 2 shows, 5-and 10-year municipals were richer relative to treasuries than 30-year municipals. Put another Chart 2: Tax-Exempt/Treasury Ratio as of 12/31/09 Maturity AAA Tax-Exempt/ Treasury Ratio 30 Year 90% 10 Year 78% 5 Year 59% Source: Bloomberg, Thompson Municipal Market Monitor (TM3) continued on page 2 MI027_C_0310 Managers I N V E S T M E N T G R O U P For more information call 800.368.4410 or visit our web site at www.managersinvest.com Mutual Funds Separate Accounts Investment Solutions
way, because 30-year tax-exempt municipals are relatively cheaper (i.e. - relative to Treasuries, yields are higher and thus more expensive for issuers), the 35% subsidy provided by BABs generates more savings for issuers at the long end. Because issuers generally save more money issuing BABs at the long-end of the curve, approximately 70% of the supply of BABs issued in 2009 had maturities greater than 20 years. This preponderance of BABs issuance at the long-end of the curve has resulted in a general lack of traditional tax-exempt issuance in that part of the curve since the BAB program ramped up. As a result, there has been a technical bid for longer bonds, which has created some flattening of the tax-exempt curve. Because spreads for A-rated and BBB-rated municipals are historically wide, lower-rated credits, in general, are the biggest beneficiaries of the BAB program. Tax-exempt municipal bonds generated strong returns during 2009 as yields fell and spreads tightened. After a strong 2009 spreads still remain elevated for A-rated and BBB-paper when compared to historic levels. Like the long-end of the curve, A-rated and BBB-rated paper is cheaper than other rating segments, which makes the BABs program especially appealing for lower-rated issuers as the cost savings from the subsidy can be significant. The Future of the Build America Bond Program As originally written into the Recovery Act, the Build America Bond Program was scheduled to conclude at the end of 2010. However, there has long been speculation that the program would be extended in a modified format. At the beginning of February 2010, that speculation was confirmed as the Obama Administration recommended a scaled back, but permanent renewal of the BAB program. When President Obama unveiled his 2011 budget he called for the permanent renewal of the BAB program. He also proposed expanding the use of BABs to include non-profit hospitals and private universities (public universities have already taken advantage of the program) as well as refundings (currently, it s only new money deals). Importantly, however, amid worries of the growing cost of the BAB program to the federal government, President Obama recommended reducing the subsidy level from 35% to 28%, making the economics of the structure less appealing to municipal issuers. If the subsidy is reduced to 28% in 2011, BABs issued in 2009 and 2010 will still receive the 35% subsidy. As a result, there is a chance that, if it makes economic sense, we may see greaterthan-expected BAB issuance in 2010 as issuers seek to lock in the 35% subsidy before the end of the year. After 2010, however, many BAB deals that would have made economic sense at a 35% subsidy will not be viable at a 28% subsidy. This is good news for investors in the highest tax bracket, particularly with the prospect of the highest marginal tax rate moving from 35% to 39.6% as the Bush tax cuts expire, as it means more supply in the tax-exempt market and continued on page 3 2
higher available yields at the margin after 2010. Lower-rated municipalities, however, will probably still benefit, even at the lower reimbursement rate and hospitals would certainly welcome the ability to tap the broader taxable market with the 28% subsidy. At the beginning of this year, market consensus for 2010 BABs issuance was approximately $100-150 billion. Again, depending on market conditions and economic circumstances this number could potentially be larger. Market expectations for total municipal issuance for 2010 are $400-450 billion. The Impact of Build America Bonds on Municipal Bond Investors The municipal bond market has always been inefficient because household investors represent 35% of the bondholders and securities are traded over-the-counter. Moreover, there are approximately 80,000 municipal issuers in the marketplace and 1.4 million CUSIPS, making research very difficult for individual investors. Municipal bond investors frequently invest in portfolios of laddered maturity bonds and do not actively seek to add value through active management. This strategy has the potential to leave significant return on the table. The introduction of BABs adds one more element of complexity to an already complex market. As the availability of new municipal bond issuance, particularly at the long end of the curve, has dwindled, it is more important than ever to understand more about the remaining municipal bonds than just their coupon and maturity. The elimination of monoline insurance, which guaranteed the timely repayment of bond principal and interest when an issuer defaults, combined with the decrease in tax-exempt paper that has occurred since the introduction of BABs, has made the municipal bond market even more complex and created opportunities for knowledgeable investors. This makes active management particularly valuable since many individual investors do not have the resources to analyze a market of this size and complexity. Active Management and Gannett Welsh & Kotler (GW&K) The creation and extension of the BABs program is a significant development for a market that many already consider very inefficient. Now is a great time for investors to consider an allocation to an actively managed municipal bond portfolio. Federal income taxes are expected to increase in the coming years and the difficulties of 2008 have reinforced the value of capital preservation. GWK is a Boston-based investment management boutique that has specialized in municipal bond investing for private wealth clients, institutions and individual clients since 1974. continued on page 4 3
The investment team focuses on maximizing the municipal opportunity for each of their individually managed client portfolios. In addition to providing clients with core municipal portfolios, they have the specialized expertise to provide enhanced-yield portfolios for clients that need more yield and will accept a bit more risk. GW&K invests across the entire yield curve they don t limit clients to just the 2- to 10- year range they position portfolios where opportunity is presented. They also take a national approach toward municipal portfolios, which provides flexibility, more liquidity, diversification and opportunity than a limited state-specific approach. GW&K s skill in trading municipal bonds brings further value added. The municipal market is a fragmented market with no central market in which to buy and sell municipal bonds. In order to skillfully trade municipal bonds, it is essential to understand the inventory of bonds and opportunity of pricing in select bonds. This is a core competence of GW&K and is fully integrated into their municipal strategies. GW&K firmly believes in actively managing municipal portfolios. Fixed income markets are continually evolving and it is important for clients portfolios to be properly positioned to take advantage of the opportunities and to manage the risk. How to Invest with GW&K Clients and Financial Advisors can access GW&K s investment expertise through mutual funds or by opening a separate account. Managers Investment Group offers two GW&K mutual funds that focus on municipal bonds: The GW&K Municipal Bond Fund combines topdown analysis to respond to interest rate changes with bottom-up research focusing on security structure and credit rating. Unlike other intermediate municipal bond funds, GW&K does not just invest in the intermediate space; it invests across the yield curve. This creates greater flexibility and a more diverse portfolio. The GW&K Municipal Enhanced Yield Fund also combines top-down and bottom-up components, but attempts to generate greater tax-free income for investors. It emphasizes lower-rated investment grade bonds and longer-term bonds that offer higher yields. This Fund can be a great complement to an existing municipal bond allocation and a way to generate additional income in a historically low interest rate environment for clients willing to accept a bit more risk. GW&K also has separate account capabilities. Its municipal bond strategy is available to clients interested in a vehicle that may offer greater flexibility and personalization. 4
Managers Investment Group Research and Analysis FEBRUARY MARCH 2010 DISCLOSURES Investors should carefully consider the Fund s investment objectives, risks, charges, and expenses before investing. For this and other information, please call 800.835.3879 or visit www.managersinvest.com for a free prospectus. Read it carefully before investing or sending money. Funds are distributed by Managers Distributors, Inc., a member of FINRA. Issuer of bonds may not be able to meet interest or principal payments when the bonds come due. The Funds are subject to the risks associated with investments in debt securities, such as default risk and fluctuations in the perception of the debtor s ability to pay its creditors. Changing interest rates may adversely affect the value of an investment. An increase in interest rates typically causes the value of bonds and other fixed income securities to fall. Factors unique to the municipal bond market may negatively affect the value in municipal bonds. Investment income may be subject to certain state and local taxes, and depending on your tax status, the federal alternative minimum tax. Capital gains are not exempt from federal income tax. High yield bonds (also known as junk bonds ) are subject to additional risks such as the risk of default. The use of leverage in a Fund s strategy can magnify relatively small market movements into relatively larger losses for the Fund. Each of us at Managers Investment Group LLC appreciates the continuing opportunity to assist you with your investing needs. If you have any questions, please call 800.368.4410. F O R I N V E S T M E N T P R O F E S S I O N A L U S E O N L Y MI025_C_0210 Managers I N V E S T M E N T G R O U P For more information call 800.368.4410 or visit our web site at www.managersinvest.com Mutual Funds Separate Accounts Investment Solutions