Fitch: Subsidy Treatment, Bond Structure Key to Build America Bond Analysis.

NEW YORK -- The treatment of subsidies as revenue versus offsets to debt service and a review of the bond structure to determine the impact on the issuer's financial flexibility are two important factors in its analysis of Build America Bonds (BABs), according to Fitch Ratings. Fitch's U.S. Public Finance group, including the U.S. infrastructure team, has rated several BABs to date and is in the process of evaluating others.

'BABs have been successful in expanding the potential investor base but it is important to consider their unique features,' according to David Litvack, Group Credit Officer of Public Finance, Fitch Ratings. 'Investors should understand how Fitch treats the federal subsidy in its analysis and how it considers the impact of new corporate bond-like structures on the municipality's future financial flexibility.'

Because they are issued as taxable debt, BABs broaden the potential investor base of municipal issuers, and because of the federal subsidy, BABs may in some cases have a lower capital cost than tax-exempt debt. The issuance of BABs does, however, introduce two credit considerations, which are the treatment of the federal subsidy in analyzing the issuer's debt position and debt service coverage and the impact of using corporate bond structures on the issuer's financial flexibility. Fitch will assign ratings to BABs based on its existing criteria for the applicable type of security, while also considering these special features of the BABs mentioned above.

The BABs Fitch has rated to date have all been direct pay, where the issuer receives a 35% interest subsidy from the U.S. government. Depending on the type of bond, specific state or local legal restrictions, and the preference of the issuer, the subsidy paid under direct pay BABs may or may not be pledged to bondholders; if the subsidy is not pledged, then the issuer may direct the subsidy to other purposes. Fitch notes that for direct pay BABs, the issuer is obligated to make the full debt service payment, not just the portion net of the expected federal subsidy. In its analysis, Fitch treats the subsidy as revenue rather than as an offset to debt service. This is consistent with how Fitch evaluates debt service coverage for other municipal bonds, giving credit to all existing revenue sources while taking into account the issuer's full future direct debt service obligation to bondholders.

To attract taxable debt investors, many BABs are being structured using features typically found in corporate bonds. For example, several BABs have been structured as non-callable bonds with a single term or bullet maturity, rather than the serial maturity structure traditionally used in tax-exempt bonds. Several structures have also used optional calls with make-whole provisions; these preclude issuers from realizing interest savings should rates decline in the future, as they can on tax-exempt municipal bonds with a traditional 10-year call feature. In its rating analysis, Fitch considers the impact of a more lumpy debt service structure and make-whole provisions on an issuer's financial flexibility. If a bond indenture does not call for sinking fund payments, then Fitch will consider the issuer's plans and ability to meet large bullet maturity payments when they come due.

The BAB program is currently scheduled to expire on Dec. 31, 2010. The program's short duration will likely limit the extent of changes to issuers' credit profiles, and Fitch does not expect to make any rating changes on the issuers' parity obligations, either positive or negative, as a result of their issuing BABs. However, were the program to be extended beyond 2010, taxable debt could become a more prominent part of a municipal issuer's capital plans, and the implications for a broader investor base, possibly offset by more corporate-like debt structures, could become more significant. Fitch will continue to follow developments in the market and will publish relevant research as it rates these bonds.

BABs were created under the American Recovery and Reinvestment Act of 2009 (ARRA), which was signed into law on Feb. 17, 2009. ARRA authorizes state and local governments to issue taxable bonds that are eligible for federal subsidies to finance any government purpose for which tax-exempt government bonds could be issued under Sect. 103 of the Internal Revenue Code. BABs must comply with all requirements for tax-exempt government bonds. There is no limit to the amount that may be issued; however, as the program now stands, BABs may not be issued past Dec. 31, 2010.

There are three types of BABs: direct pay, tax credit, and recovery zone. Under direct pay, the issuer receives a subsidy from the U.S. government equal to 35% of the bond coupon. For tax credit BABs, 35% of the interest payable is paid to the investor in the form of a tax credit. Recovery Zone Economic Development bonds must be issued to benefit a recovery zone and are eligible for a 45% interest subsidy from the U.S. government.

Fitch's rating definitions and the terms of use of such ratings are available on the agency's public site, www.fitchratings.com. Published ratings, criteria and methodologies are available from this site, at all times. Fitch's code of conduct, confidentiality, conflicts of interest, affiliate firewall, compliance and other relevant policies and procedures are also available from the 'Code of Conduct' section of this site.