Bank Qualified Bonds
Description of Bank Qualified Bonds
Banks, like other investors, purchase municipal bonds in order to obtain the benefit of earning interest that is exempt from Federal income taxation. Historically, commercial banks were the major purchasers of tax-exempt bonds. Banks' demand for municipal bonds changed in 1986 with the passage of the Tax Reform Act of 1986 (the "Act"), now under section 265(b) of the Internal Revenue Code of 1986, as amended (the "Code").
Under the Code, banks may not deduct the carrying cost (the interest expense incurred to purchase or carry an inventory of securities) of tax-exempt municipal bonds. For banks, this provision has the effect of eliminating the tax-exempt benefit of municipal bonds. An exception is included in the Code that allows banks to deduct 80% of the carrying cost of a "qualified tax-exempt obligation." In order for bonds to be qualified tax-exempt obligations the bonds must be (i) issued by a "qualified small issuer," (ii) issued for public purposes, and (iii) designated as qualified tax-exempt obligations. A "qualified small issuer" is (with respect to bonds issued during any calendar year) an issuer that issues no more than $10 million of tax-exempt bonds during the calendar year.(1) Qualified tax-exempt obligations are commonly referred to as "bank qualified bonds."
Effectively two types of municipal bonds were created under the Act; bank qualified (sometimes referred to as "BQ") and non-bank qualified. Although banks may purchase non-bank qualified bonds they seldom do so. The rate they would require in order for the investment to be profitable would approach the rate of taxable bonds. As a result, issuers obtain lower rates by selling bonds to investors that realize the tax-exempt benefit. In contrast, banks have a strong appetite for bank qualified bonds that are in limited supply. As a result, bank qualified bonds carry a lower rate than non-bank qualified bonds.
Interest Rate Differential
Any rate differential between bank qualified and non-bank qualified bonds only impacts the maturities purchased by banks. Few studies have analyzed the rate difference between bank qualified and non-bank qualified bonds. Based on bond purchase proposals and bids received, WM Financial Strategies believes that prior to 2008 the rate differential was generally between 10-25 basis points (.10% to .25%) on maturities purchased by banks. Generally banks purchased shorter maturities of bonds (maturing in ten or fewer years). With the credit crisis of 2008, the rate differential increased to as much as 50 basis points and applied to maturities as long as twenty years. With the passage of the American Recovery and Reinvestment Act of 2009 the rate differential substantially declined and was often undetectable.