| DEFINITION: Tax credit securities are subsidy bonds that pay investors interest exempt from federal taxation and potentially state taxation in the issuing state. |
Tax credit securities help municipalities issue at lower rates.
The American Recovery and Reinvestment Act of 2009 created several subsidy bonds to help offset the burden of the 2008 market crisis. They included Build America Bonds (BABs), Qualified School Construction Bonds (QSCBs), and Clean Renewable Energy Bonds (CREBs).
The two types of federal subsidies are: (1) direct pay and (2) tax credit.
With direct pay securities, the federal government reimburses the issuer a percentage of the interest it pays every to investors instead of offering tax credits. Thus, that issuer makes a lower net interest payment, although the investor will still receive the full 6%. Issuers of this type of bond often offer higher coupon rates than other issuers.
With tax credit securities, investors purchase bonds at a lower coupon because some of that interest is federally tax-deductible and sometimes state tax-deductible. This means the investor keeps more of their interest income. As a result, the issuer can issue the bond at a lower coupon rate.
No federal subsidy bonds are being issued currently, but some are still outstanding.
| EXAMPLE: A bond pays a 35% subsidy to investors as a tax credit on their interest income. By reducing an investor’s income tax liability, the investor will likely agree to a bond with a lower coupon rate than they would otherwise accept. |
What’s important here?
Many federal subsidies are tax credit securities, meaning that instead of reimbursing the issuer, they reimburse investors on some of their interest earnings by giving them a tax credit.