California greenlights ‘Build America’ bond sale despite questions about U.S. subsidy payments

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California plans to proceed this week with a sale of federally subsidized bonds to finance infrastructure projects, despite fears raised about the Internal Revenue Service’s ability to claw back subsidy payments.

Treasurer Bill Lockyer hopes to sell $1.325 billion of so-called Build America Bonds, which pay taxable interest that is partially subsidized by the U.S. Treasury.

Questions were raised about California’s sale after Florida’s finance director, Ben Watkins, on Thursday canceled that state’s sale of $265 million of Build America Bonds that also was slated for this week.

Watkins said he pulled the deal because of concerns that the IRS could intercept subsidy payments for the bonds if the issuer owed the federal government money for programs such as Medicare.

Tom Dresslar, a spokesman for Lockyer, said California was aware of the IRS’ ability to put a claim on subsidy payments but that the issue wasn’t new. States and municipalities have sold more than $80 billion of Build America Bonds since the program was launched by the Obama administration one year ago. California has been the single biggest issuer of the bonds, which fund public-works projects.

‘We’re not going to shut down a job-creation machine on the idea that there may be [subsidy] offset issues later on,’ Dresslar said. In any case, California would be responsible for making full payments to investors, whether the U.S. paid its promised subsidy or not.

Under the Build America program, state and local governments issue taxable bonds at market interest rates, and the Treasury agrees to pay 35% of their interest cost for the life of the bonds. The arrangement generally has resulted in lower net interest payments for the issuers than if they sold standard tax-exempt municipal bonds.

Because the debt is taxable, the program also has provided state and local governments with new sources of investment demand: pension funds, life insurance companies and others that generally don’t buy tax-free bonds.

Lockyer this week also plans to sell about $675 million of taxable bonds that won’t be issued under the Build America program.

The state this month has been ramping up debt sales for voter-approved infrastructure projects. On March 11 Lockyer sold $2.5 billion of tax-free muni bonds. Despite the state’s weak credit rating (the lowest of the 50 states) investor demand was robust, reflecting the above-average interest rates California continues to pay to borrow.

Individual investors were eager buyers of the tax-free bonds. By contrast, the state typically aims to sell its taxable bonds, including Build America issues, to institutional investors.

This week’s bond sale will be marketed to investors on Wednesday. The yields on the bonds will be set on Thursday.

-- Tom Petruno