The Budget Control Act of 2011 requires automatic spending cuts ("sequestration") to begin January 2, 2013, as the result of Congress' failure to enact legislation to reduce the budget deficit.  Among the federal expenditures affected by these cuts are subsidies due to state and local governments which issued bonds pursuant to several bond programs authorized by Congress during the depths of the economic downturn.  Those programs provided for the issuance of taxable bonds and the payment of a subsidy from the federal government to the issuer to approximate the benefits of issuing bonds with tax-exempt bonds.  These direct-pay subsidy bond programs included Build American Bonds, Qualified Zone Academy Bonds, Qualified School Construction Bonds, Qualified Energy Conservation Bonds, and New Clean Renewable Energy Bonds.

The Office of Management and Budget ("OMB") has released a report which estimates the impact of the Congressionally-mandated automatic spending cuts which will occur if sequestration goes into effect.  A link to the OMB report can be found at the following address: http://cdn.govexec.com/media/gbc/docs/pdfs_edit/091412cc1.pdf.  The OMB report shows that the federal subsidy payments for the federal fiscal year ending September 30, 2013, may be cut by 7.6%.  For Build America Bonds alone this would be approximately $255,000,000 in FY2013.  The OMB report notes:

"The estimates and classifications in the report are preliminary.  If the sequestration were to occur, the actual results would differ based on changes in law and ongoing legal, budgetary, and technical analysis."

Nonetheless, issuers of any of the direct-subsidy bonds should consider how these proposed cuts may impact their budgets and compliance with bond covenants.  In some cases, issuers account for the subsidy in the general fund.  In other cases, issuers pledge the subsidy to bondholders.  When the subsidy is pledged to bondholders, issuers will want to consider how these cuts could impact the ability to pay debt service.  Also, these cuts may impact compliance with rate maintenance covenants or additional bonds tests.  Finally, issuers will want to consult the redemption provisions for their bonds to determine whether these cuts may implicate an extraordinary redemption provision.

To avoid sequestration, Congress must enact legislation reducing the budget deficit by $1.2 trillion or repealing or modifying the sequestration provision of the Budget Control Act of 2011.  This could occur during the lame duck session after the election or when the new Congress convenes in January.