Summary

On March 1, sweeping sequestration cuts to the federal budget, mandated by the Budget Control Act of 2011, were ordered, some of which directly affect a portion of the municipal bond market. Among the reductions are interest subsidy payments the federal government makes to issuers of “direct pay bonds” (i.e., build America bonds and recovery zone economic development bonds, and most qualified school construction bonds, qualified zone academy bonds, new clean renewable energy bonds, and qualified energy conservation bonds). Sequestration also slashes federal funding for a number of state and local transportation, education, and health care programs, potentially threatening the budgets of state and local governments.

Direct Pay Bonds

Sequestration requires a 5.1% cut in the total payments made to issuers of direct pay bonds in federal FY2013, which ends September 30. Because many of these FY2013 payments have already been made, future payments over the balance of the fiscal year will have to be reduced by more than 5.1% to meet the goal. For direct pay bonds, the IRS has announced that the percentage reduction will be 8.7%. This means that all direct payments from now through September 30, 2013 (subject to future legislative action) will be 8.7% less than what they would be absent sequestration. The IRS has issued a notice announcing that, while issuers should continue to file for interest subsidy payments on Form 8038-CP as usual, the IRS will reduce the direct payments by 8.7% and will send notification of the reduced payment.

Issuers should also review their direct pay bond documents to determine whether the reduced subsidy affects their redemption rights.

Other Federal Cuts

Sequestration will slash more than $600 million from the Federal Aviation Administration’s budget, $101 million from federal emergency highway funds and $354 million from non-emergency spending of the Federal Highway Administration. Some of these cuts will reduce or eliminate funds that would have been paid to state and local governments for transportation initiatives. Other reductions will eliminate federal funding that many states and local governments use to fund social services and healthcare programs. In addition, cuts to various educational programs will require already cash-strapped school districts to do more with less.