Washington state’s massive deal latest to test BAB redemption

Bonds

The state of Washington is the second large issuer to face pushback from investors as it heads to market with a deal to refund Build America Bonds using extraordinary call provisions.

Wells Fargo Securities, leading a seven-bank syndicate, plans Tuesday to price $1.08 billion of Washington state motor fuel tax and vehicle related fees refunding revenue bonds in a deal to refund outstanding Build America Bonds issued in 2009 and 2010.

The deal comes after a group of investors sent a letter challenging the legality of the Regents of the University of California’s ability to trigger an extraordinary optional redemption provision to refund their outstanding BABs ahead of a March 5 deal. On Wednesday, a second letter was sent, this time from the law firm Kramer Levin, threatening a lawsuit if the Regents of the University of California “fail to cancel the redemption or pay the make-whole redemption amount.”

Investors sent email queries to Washington Deputy Treasurer Jason Richter about the state’s plans to trigger an extraordinary optional redemption provision to redeem Build America Bonds.

Washington State Treasurer’s Office

On March 6 and 7, two investors sent email queries to Washington state deputy treasurer Jason Richter asking if the state would go forward with BABs redemptions as part of its upcoming deal, given investor protests.

The state plans to proceed with its bond pricing on Tuesday, said Aaron Sherman, an Office of the State Treasurer spokesman, who declined to comment further on the deal or the BABs issue until after the deal prices.

The state’s finance team includes Piper Sandler and Montague DeRose as co-municipal advisors and Foster Garvey as bond counsel.

BABs are the only refunding candidates identified in the preliminary official statement for the sale.

Ahead of the deal, AA-plus, Aaa and AA-plus ratings were affirmed by Fitch Ratings, Moody’s Ratings and S&P Global Ratings, respectively.

BABs, authorized in 2009 and 2010 as part of a stimulus program during the Obama administration, allowed issuers to sell taxable bonds and receive a subsidy from the federal government.

Federal budget “sequestration” has resulted in lower-than-promised subsidies to issuers since 2013.

Issuers have moved to call outstanding BABs following a recent U.S. Supreme Court ruling that, according to a February publication from law firm Orrick, supports the conclusion that sequestration “resulted in a materially adverse change to the cash subsidy payment obligation.”

The letter from law firm Kramer Levin argues the Orrick opinion is “unsound.”

J.P. Morgan has identified 14 “unique” issuers that have either called BABs, posted conditional calls or announced that they are considering financing plans. The six in California have outstanding BABs totaling $6 billion, according to JP Morgan.

The large issuers in California include Los Angeles Unified School District, which posted a notice of intent to refinance on February 16 that included the Series RY 2010 worth $1.25 billion at par and Series KRY 2009 BABs worth $1.369 billion at par. Timothy Rosnick, LAUSD’s director of capital planning and budgeting, couldn’t be reached for comment on the district’s BABs.

Mia Rose Wong, a spokeswoman for the Los Angeles Department of Water and Power, which posted a redemption notice for its BABs on EMMA Tuesday, declined to comment. LA DWP announced it plans to redeem on April 18 $316 million of bonds with a July 1, 2039, maturity at a redemption price of 103.619%, citing the extraordinary optional redemption in its notice.

There is one “unique” issuer from Virginia ($266.10 million), Maryland ($721.14 million), Indiana ($65.16 million), New York ($155.88 million), North Carolina ($208.06 million), Kentucky ($428.29 million), Texas ($79.58 million), and Washington ($1.22 billion), according to J.P. Morgan.

Washington’s state government identifies $1.22 billion of BABs as refunding targets in the official statement for next week’s deal.

Tasa Richardson, a spokesperson for Midland Health, the Texas issuer, said in an emailed response Thursday that Midland County Hospital District has no plans to refinance its BABs; the district had posted notice of a potential bond financing on EMMA in January that mentioned taxable direct subsidy BAB limited tax bonds.

James Pruskowski, chief investment officer at 16Rock Asset Management and a market participant who holds no BABs, predicted the bondholder letter to UC Regents, and now emails to Washington, will lead issuers to be a little more reluctant to come to market, as it’s “a ‘see as you go’ type of situation.”

BABs that have the option to exercise these extraordinary redemption provisions are mostly concentrated in “these big sophisticated issuers with densely populated areas and mostly on the coastal regions, such as New York, California and Washington,” he said.

Bondholders have enjoyed several years of strong income and stable prices, so it can be “painful to lose that premium to an ERP being exercised,” Pruskowski said.

Despite investor protests, UC Regents went ahead and priced $1.1 billion of general revenue bonds on March 5. The proceeds refunded its BABs debt sold in 2009 and 2010. Closing is scheduled March 27, according to information posted to the Municipal Securities Rulemaking Board’s EMMA disclosure website.

A UC spokesman had declined to comment on the situation ahead of pricing. Orrick, the university’s bond counsel, told The Bond Buyer after the pricing that professionals on the deals had likely advised their clients “investors would not be happy,” though he wouldn’t comment on UC’s deal specifically.

The bondholders wrote in the initial letter that the Regents had no “legal basis” to redeem the securities pursuant to exercising the EOR provision.

The registered bondholders that signed the initial letter include MetLife Investment Management, Safety National Casualty Corp., DCM US Credit Fund, Mackay Shields, PGIM, Hartford Investment Management Company and several insurance companies including Houston Casualty and Philadelphia Insurance.

However, it is unclear if the signees of the original letter are represented by Kramer Levin.

A separate set of investors sent query emails to Washington’s deputy treasurer asking about the state’s upcoming deal that were obtained by The Bond Buyer.

“Our interpretation of the BAB redemption provision is an extraordinary event will occur if there’s a material change to Section 54AA or Section 6431, and the current sequestration rate of 5.7% wouldn’t qualify, thus requiring state treasurers to prefund or tender bonds at the whole spread if they want to refinance,” wrote Jonathan Souza, director of Credit Research, who said his firm had a modest exposure to the state’s BABs.

He then referenced the investor letter challenging the UC Regents BABs redemption adding that “any insight into the state’s decision to consider refunding bonds via the extraordinary call provision would be greatly appreciated.”

The state preliminary offering statement posted Monday says that the state has determined an “extraordinary event” has occurred with respect to the 2010D and 2010F refunding candidates permitting extraordinary optional redemption. The 2010D BAB refunding candidates are three series with a redemption price totaling $428.2 million, while the 2010F series has a redemption price totaling $794.3 million, according to bond documents.

Brian Pacheco, assistant vice president with Amica Mutual Insurance Co., who said his firm holds $80 million in book value of Washington state’s BABs purchased in the primary and secondary markets, said in his email to Richter his firm views the state as a “high quality credit” and is “committed to the state, but the recent redemption call notices gives us pause.”

He added that many banks and insurance companies purchased the bonds in the secondary market and hold them at amortized cost.

“That means that since we purchased many of these bonds in the secondary market at prices well in excess of par (ranging between 108 – 125 percent of par), as many investors did during the low interest rate environment, and that those prices amortize down to par over the course of the remaining maturity of the bond, the book value of our longer maturity State of Washington BABs (2033, 2039, 2040 maturities) have not amortized all that much. They are all above 110% of par today. That is well in excess of the ERP call prices,” he wrote.

“This will result in large book losses for all insurance companies and banks that hold State of Washington BABs,” he wrote. “While we understand this is unique to banks and insurance companies since we hold our bonds on the books at amortized cost, we are among the investors in municipal bonds and would like to bring this to your attention,” he said.

Washington state probably has more “leeway” to go ahead and refund outstanding BABs by triggering an ERP than some other issuers that have more “restrictive language,” said an investor tracking Washington’s deal, who said his firm had little exposure to the state’s BABs, but asked to not be named.

For those with “restrictive language,” a 5.7% reduction in the interest rate subsidy is not “material,” according to the investor.

Even if bond attorneys can agree that issuers can proceed and trigger extraordinary redemptions, there are still net present value savings, they said.

Over the past several months, there has been a “trifecta” where spreads have fallen lower than the trigger, making it more enticing for issuers to refund outstanding BABs through ERPs.

“The premiums that are on these bonds are getting closer to par, so it’s not as expensive to take them out of the market,” they said.

The recent court case, Indiana Municipal Power Agency v. U.S., was a “bombshell,” as it said issuers were “in their right” to refund BABs through ERPs, according to the investor.

“That was one of the final straws,” they said.

The investor said they are curious as to what went into Washington state’s decision to refund BABs through extraordinary redemption provisions.

“Bond investors need to know the risks, and in the language, it’s all been up for interpretation,” they said.

Karen Pierog contributed to this story.

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