The Potential Benefits of a New Direct Payment Bond
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The Brief
- As BPC previously outlined, COVID-19 and related shutdowns have hit state and local government budgets hard, making it more difficult to take out debt and finance needed infrastructure improvements.
- One solution to this challenge being considered in Congress is the authorization of a new, federally subsidized “direct payment” bond.
- We find that a new direct payment bond could lower borrowing costs for public entities, attract a broader class of investors, more efficiently subsidize projects, and give state and local governments another financial tool in their toolkit.
Direct payment bonds have a successful history of encouraging infrastructure investment during times of economic uncertainty. Unlike traditional municipal bonds, the interest earned on direct payment bonds is taxable, which makes them attractive to investors without tax liabilities, such as pension funds. Instead of allowing investors to deduct bond interest from their taxes, the federal government subsidizes the state or local issuer with a “direct payment” equal to a certain percentage of the interest rate. This model offers a more attractive interest return for bondholders while simultaneously lowering the borrowing costs for local issuers.
Build America Bonds were a type of direct payment bond issued during the Great Recession as part of the American Recovery and Reinvestment Act of 2009. They were created in response to municipal bond market disruptions—a nearly 70% decline in new municipal bond issuances and 100% increase in borrowing costs at the end of 2008—and intended to help state and local governments that were struggling to finance needed projects.
From April 2009 to December 2010, the federal government could provide a subsidy, equivalent to 35% of the interest rate, directly to local issuers or as a tax credit to investors. Over the course of the program, $182 billion in Build America Bonds were issued by all 50 states, the District of Columbia, and two territories. According to a Treasury Department report, the program effectively revived bond issuances and supported various infrastructure projects, including smaller developments such as schools and community centers. Most notably, issuers were found to save an average of 84 basis points on interest costs for 30-year bonds, amounting to an estimated savings of $20 billion in borrowing costs over the course of the program. The taxable nature of these bonds allowed state and local governments to accumulate net savings over the cost of the federal subsidy. In other words, the federal investment paid off.
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The Role of Direct Payment Bonds During COVID-19
A direct payment bond program may allow state and local governments to finance critical infrastructure projects at a lower cost compared to traditional municipal bonds. While the current state of the municipal bond market is not as dire as it was during the Great Recession, state and local governments face a challenging budget and economic outlook. With the volatility in the municipal bond market at the outset of the pandemic and the continued risk of COVID-19-related financial hardships and economic disruptions, a new direct payment bond could help restore investor confidence while giving governments a tested financial tool to help them meet their infrastructure investment needs.
The original Build America Bonds program was not renewed due to partisan disagreements, particularly over the appropriate level of subsidy, but the model of a subsidized, taxable bond could serve a critical long-term role in infrastructure financing. Moreover, several legislation proposals are being actively considered in Congress. Section 90101 of H.R. 2, the Moving Forward Act, which passed the House in July 2020, proposes a new direct payment bond program, initially with a 42% interest rate subsidy that decreases to 30% by 2027. Sens. Roger Wicker (R-MS) and Michael Bennet (D-CO) also introduced the American Infrastructure Bonds Act. Under their proposal, state and local governments would be able to issue taxable bonds, receiving a 35% subsidy for issuances through 2025 and a 28% subsidy for those issued thereafter.
While passing an infrastructure package becomes less likely as the general election approaches, these proposals serve as valuable starting points for a new direct payment bond program. They demonstrate such a proposal’s bipartisan support and affirm the appeal of direct payment bonds as an economic stimulus tool. However, further steps can improve the program to better serve our infrastructure needs:
- Reach a bipartisan agreement for the appropriate interest rate subsidy. Disagreements over the appropriate level of federal subsidy halted the renewal of the Build America Bonds program in 2010. Democrats proposed an extension of the program with a 28% subsidy, which prompted rebuke from Republicans who feared that the rate would impose costs on taxpayers. According to a NBER report, there is a valid concern that the program transferred wealth from individual U.S. taxpayers to institutional investors. House Democrats’ proposal for a direct payment bond with a 42% subsidy could reignite these same concerns. More research should be conducted to ascertain a level of subsidization that would encourage capital projects without putting too much pressure on an already strained federal budget.
- Increase the scope of direct payment bond issuances beyond new construction. The Build America Bonds program limited direct payments to new construction projects, therefore restricting funds raised by these issuances to “shovel-ready” projects. A new direct payment bond should more flexibly allow state and local governments to finance their most pressing needs—whether infrastructure repair and modernization, new investments in resilience, or other high-priority projects.
- Extend the use of direct payment bonds to public-private partnerships. Build America Bond financing was only available for publicly owned projects. However, private companies can bring valuable expertise, innovation, and capital to infrastructure projects. Public-private partnerships have helped public agencies save costs, share risks, and maximize asset value. Direct payment bonds, issued by public partners on behalf of private firms building public-use infrastructure projects, could be another way to leverage private capital for infrastructure. In addition to private activity bonds which support privately-owned developments, direct payment bonds would draw in a wider range of investors. Other proposals to support public-private partnerships, such as the Move America Bonds introduced by Sens. Ron Wyden (D-OR) and John Hoeven (R-ND), would similarly allow governments to meet their infrastructure needs regardless of project delivery method.
Conclusion
Though the COVID-19 pandemic has stalled some infrastructure projects, it has also highlighted the importance of safe, modern infrastructure to our health, wellbeing, and economy. As Congress considers additional coronavirus relief measures, surface transportation reauthorization, and other infrastructure bills, lawmakers will inevitably face the question of funding. Providing innovative financing options does not absolve policymakers from having a tough conversation about how to ultimately pay for needed infrastructure improvements, but a direct payment bond could help struggling state and local governments more flexibly address their infrastructure needs at this critical time. If implemented with efficiency and affordability in mind, direct payment bonds also have the potential to attract broad, bipartisan support.
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