For years, the municipal bond market has been the primary source of capital for U.S. infrastructure. Recently, other types of bonds have also played a role in financing projects. This post compares three types of bonds that are or have been used for infrastructure: tax-exempt bonds, direct payment bonds, and private activity bonds. These bonds are a form of debt issued by state or local governments, and all are subsidized by the federal government. The bonds differ from each other in two key ways: (1) what projects are eligible, and (2) what type of federal support they receive.
Tax-exempt bonds: Tax-exempt bonds, also known as municipal bonds or “muni” bonds, are issued by state and local governments and other governmental entities to raise capital for public purposes. Because investors don’t pay federal taxes on the interest they earn, they are willing to accept a lower interest rate than they would on a taxable bond, making financing cheaper for state and local governments. The federal government incurs a cost from these bonds in terms of foregone tax revenue.
- These bonds can be used for all types of publicly owned infrastructure.
- The tax-exempt bond market is very deep and liquid, with millions of investors.
- Transactions are standardized and information about issuers’ creditworthiness is readily available, keeping transaction costs low.
- Tax-exempt bonds are generally only available for projects that are publicly owned and managed, which prevents many public-private partnerships from qualifying and limits localities’ ability to transfer projects built with tax-exempt financing to private ownership or management.
- The tax exemption makes these bonds attractive to investors with federal tax liability but not to investors who do not pay federal taxes, such as pension funds, life insurance companies, and funds run by foreign governments (known as “sovereign wealth funds”).
Given America’s broad needs and the wide range of potential investors, financing options should include all of the above.
Direct payment bonds: Direct payment bonds are another form of state and local government debt. Unlike tax-exempt bonds, the interest on direct payment bonds is taxable. Because purchasers of these bonds will have to pay taxes on the interest, they require a higher interest rate than they would on tax-exempt bonds. Rather than using a tax exemption to make this form of financing cheaper for state and local governments, the federal government makes a direct payment to the state or local issuer of the bond, equal to a specified percentage of the interest. In effect, the federal government pays a portion of the interest on the bond.
This type of bond was authorized for a limited period in the 2009 American Recovery and Reinvestment Act under the name “Build America Bonds,” or “BABs.” Over the next two years, $181 billion in BABs were issued. Under the BABs program, the federal government provided a payment to state and local issuers equal to 35 percent of interest. The Obama administration’s proposal to reauthorize BABs would have lowered the payment to 28 percent of interest—reducing the cost to the federal government but also reducing the benefit to state and local governments.
- Direct payment bonds are attractive to both investors that do not pay federal taxes and to investors that do. They are attractive to investors that do not pay federal taxes because the value of the bond does not depend on the purchaser’s tax status (unlike tax-exempt bonds, where part of the value comes from the tax exemption). Investors who do pay federal taxes will still purchase these bonds because the higher interest rate compensates for the federal tax liability.
- Federal payments go directly to state and local governments rather than to investors through a tax exemption. Economic studies have shown that investors in tax-exempt bonds absorb some of that benefit rather than passing its full value along to state and local issuers in the form of lower interest rates.
- New bond programs can take time to get up and running. State and local governments had to pay relatively high fees to securities firms to develop required documents and market BABs to potential buyers at the beginning of the program (though these fees had dropped by the time the program ended).
- Like tax-exempt bonds, BABs were available only for publicly-owned projects.
- The BABs program was authorized for two years, so only projects and investors who were “ready to go” could utilize the program. (This issue is not inherent to direct payment bonds, and a future authorization could be for a longer period.)
- The direct payment to issuers was reduced by the 2013 sequester, undermining confidence in the program.
Private activity bonds: Private activity bonds, or “PABs,” support the development of projects that are owned or managed by a private entity. Like municipal bonds, PABs offer tax-exempt interest as long as the bond is issued to finance a qualifying project. The types of projects that qualify under current law include airports, docks, and water and sewer facilities, among others.
- PABs bring the benefits of tax-exempt debt to privately-owned or managed projects that have a public purpose.
- Like tax-exempt debt, PABs are issued by a public agency, but payment of principal and interest comes from the private partner and don’t impact the public agency’s credit rating or debt limit.
- Like muni debt, PABs are less attractive to investors who do not have federal tax liability.
- While interest on PABs is generally exempted from federal income taxes, it is subject to the Alternative Minimum Tax (AMT), so purchasers of these bonds will require higher interest than traditional tax-exempt debt, making this form of financing more costly.
- PABs currently have a statutory “volume cap” that limits the amount that may be issued in each state. Transportation-related PABs have a separate authorization totaling $15 billion, which is allocated among qualifying projects by the Department of Transportation.
A note about Move America Bonds, a specific type of private activity bond proposed by Sens. Ron Wyden (D-OR) and John Hoeven (R-ND): Like other PABs, Move America bonds could be issued by public entities on behalf of a private partner for a qualifying infrastructure project. Move America bonds would have their own volume cap, separate from other PABs. Unlike traditional PABs, Move America bonds would not be subject to the AMT, making them more attractive to investors who are subject to that tax and keeping interest rates more in line with traditional tax-exempt debt. Move America Bonds could also be converted into tax credits, a topic that will be covered in a separate post.
Given America’s broad needs and the wide range of potential investors in infrastructure bonds, financing options should include all of the above. BPC’s Executive Council on Infrastructure, in its 2016 report, recommended that the well-established tax-exempt bond market, which has proven to be an extremely effective way to support infrastructure, be preserved, that private activity bonds be expanded to ensure that public-private partnerships can access tax-preferred financing, and that taxable direct payment bonds should be made available again to attract a broader range of investors. Notably, these goals could also be accomplished through a combined approach: complementing the existing tax-exempt market with a new direct payment bond for which all projects with a public purpose, whether publicly or privately owned, are eligible.