Direct-Pay Bonds and Potential Reduction of Federal Payments Under Sequester

    September 2012

    The United States Office of Management and Budget recently reported that budget sequestration could reduce federal interest subsidy payments made to issuers of outstanding Build America Bonds, Qualified School Construction Bonds, Qualified Zone Academy Bonds, Recovery Zone Economic Development Bonds, Qualified Energy Conservation Bonds and Clean Renewable Energy Bonds (generally referred to as direct payment bonds). In addition, sequestration could reduce other federal payments to states and local governments, including federal grants for capital projects and health and education programs.

    Under the Budget Control Act of 2011, if Congress fails to agree upon sufficient reductions in the federal deficit, automatic spending cuts will be triggered. This budgetary sequestration would take effect January 2, 2013. On September 14, 2012, the White House released a report of the Office of Management and Budget documenting the cuts that sequestration would require in fiscal year 2013. According to this report, sequestration would result in a 7.6% cut in the interest subsidy payments made by the federal government during 2013 to issuers of direct payment bonds. Similarly, sequestration could result in a 7.6% or 8.2% reduction, depending on the type of payment, in other federal payments to states and local governments. Absent sufficient reduction in the federal budget deficit, an indeterminable amount of cuts may also be made in fiscal year 2014 and beyond.

    These cuts will not occur if Congress enacts sufficient budget deficit reductions, or changes the law mandating these reductions, by January 2, 2013. Alternatively, Congress could subsequently revise the federal budget or change applicable law retroactively in a manner that would avoid cuts in the interest subsidy and other federal payments.

    Direct payment bonds generally can no longer be issued. However, certain categories of direct payment bonds, such as direct payment Qualified Zone Academy Bonds and Qualified Energy Conservation Bonds, can be issued until applicable volume limits have been exhausted. Issuers considering issuing such direct payment bonds should take this potential sequestration into account.

    Early redemption provisions should also be reviewed in light of this announcement. Many direct payment bonds have extraordinary redemption provisions that permit the issuer to call the bonds if the issuer will not or does not receive the full federal interest subsidy.

    Issuers of Build America Bonds and other direct-pay bonds should continue to monitor actions of the US Congress toward deficit reduction and should consider the possible effect of a reduction in interest subsidy payments on the issuer’s budget. In addition, issuers of such bonds should review any applicable optional redemption provisions. If you need assistance with this review, please call your Squire Sanders contact.