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 ($30 million during calendar year 2009 and 2010 - see "American Recovery and Reinvestment Act of 2009").  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. 

American Recovery and Reinvestment Act of 2009

Under the American Recovery and Reinvestment Act of 2009 (the "2009 Act"), several changes were made that will encourage investment in tax-exempt bonds by banks. These changes are effective only for tax-exempt securities issued in 2009 and 2010. First, the 2009 Act creates a temporary safe harbor (2% de minimis” rule) that permits financial institutions to deduct 80% of the cost of buying and carrying tax-exempt bonds to the extent their tax-exempt holdings do not exceed 2% of their assets. Second, the $10 million bank qualified bond limit is changed to $30 million.  Borrowers that participate in a pool or borrow through a conduit issuer issuing more than $30 million in a calendar year will be entitled to bank qualification as long as the borrower's total tax-exempt financings are under $30 million in the calendar year.

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.

It is predicted that the rate differential will significantly contract and could disappear entirely while the new 2% de minimis rule and $30 million bank qualified provision of the 2009 Act are in effect. This is due to the fact that a large amount of all tax-exempt bonds issued in 2009 and 2010 will be bank qualified and, furthermore, banks will also buy tax-exempt bonds that are not designated as "bank qualified" as a result of the 2% de minimis rule. 

Issuing Bank Qualified Bonds

Any issuer that is planning to issue less than $10 million of tax-exempt securities in a calendar year ($30 million in 2009 and 2010) should designate the issue as bank qualified in order to obtain the associated interest cost savings. Issuers requiring more than $30,000,000 in 2009 and 2010 may be able to take advantage of bank qualification by issuing two series of bonds. For example, for a $40,000,000 financing, a $20,000,000 issue could be sold this year and one issue could be sold next year to obtain 2 bank qualified issues.  Similarly, for a $70,000,000 financing, $30,000,000 could be sold as bank qualified bonds this year and a non-bank qualified $40,000,000 issue could be sold next year.  

A detailed cost analysis should be made prior to splitting an issue.  First, a determination should be made as to whether the interest cost savings from bank qualification will offset the added costs of issuance associated with two bond issues.  Second, in today's volatile market, a small deferral of a bond sale can result in dramatically higher interest rates that more than offset the rate reduction from bank qualification.  For example, from September 11 to October 16, 2008 interest rates rose almost 1.50%.  Accordingly, even a short-term deferral of a bond sale could be extremely costly. Finally, and as noted above, the changes made under the 2009 Act may reduce and potentially eliminate the rate differential between bank qualified and non-bank qualified bonds.