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Build America Bonds

by Cara Scatizzi

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Build America Bonds (BABs) are new taxable municipal bonds that were authorized in February under the American Recovery and Reinvestment Act of 2009.

These new bonds allow state and local governments to issue taxable bonds in 2009 and 2010 for government capital projects; the issuers receive a direct subsidy payment from the U.S. Treasury for a portion of their borrowing costs. The intent is to provide municipal issuers access to a broader market of buyers, such as tax-exempt and lower-tax-bracket investors. In turn, these investors now have a new bond option—municipal bonds that pay an interest rate that is competitive with other taxable issues, such as corporate bonds.

How It Works

BABs were created to help state and local governments finance capital projects at a lower cost due to the government subsidization of interest paid. The interest subsidy is a rate of 35%. The hope is that issuers will create new jobs and stimulate the economy with new projects.

Issuers are only allowed to use the proceeds from these bonds for government capital projects. These kinds of projects create public infrastructure like public schools, roads, transportation infrastructure and public buildings. Private companies cannot issue these bonds.

Typically, municipal bonds pay a lower interest rate than taxable bonds because the interest is exempt from federal taxes. This makes them unattractive to investors who cannot take advantage of the federal tax exemption—for example, tax-exempt institutional investors such as pension funds, tax-exempt investors (401(k)s and IRAs), and lower tax-bracket investors.

With the advent of BABs, the government subsidy allows municipal issuers to offer higher interest rate payments than the issuer otherwise would be able to afford—one that is more competitive with other taxable issues, such as corporate bonds.

For example, in early 2009 the state of California issued BABs maturing in 2039 and rated A by S&P and Fitch, that offered an interest rate of 7.4% to investors; thanks to the subsidy, however, the state had to pay only 4.8% of that interest, with the federal government picking up the rest.

According to the Securities Industry and Financial Markets Association (SIFMA), during the second quarter of 2009, 33 states issued BABs to the tune of $15.3 billion, representing about 14% of the long-term municipal bond market. Wisconsin issued the largest number of BABs with 16, while California issued the most by dollar amount with $5.753 billion.

Most of the BABs issued have had maturities of 20 years and longer.

Types

There are two main types of Build America Bonds.

Direct Payment BABs

For direct payment BABs, the U.S. Treasury pays the issuers 35% of the coupon interest payments on the bonds. The intention of the credit to issuers is to lower their cost of issuing bonds. It is up to the issuer to return some or its entire interest savings to the bondholders by paying a higher interest rate.

Tax Credit BABs

For tax credit BABs, instead of a subsidy that goes to the issuer, the subsidy goes to the BAB holders, who receive a tax credit equal to 35% of the interest on the bonds. If the bondholder’s tax liability is insufficient to use the entire credit, it can be carried forward to future years.

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How to Invest

BABs have been extremely popular with investors—particularly institutional investors—because of the competitive interest rates they have paid.

Like most new issues of stock, most of the new large BAB issues sell out to institutional investors—it is hard for individuals to get in on these bonds at issuance.

However, these bonds do trade in the secondary market after they are issued. You might pay a premium for the bond, but you will be able to reap the benefits of the interest payments.

In addition, some smaller issues, which draw less attention from institutional investors, may allow individuals to purchase the bonds at issuance.

Talk to your broker or an investment professional for more information about buying these bonds at issuance or in the secondary market.

Investor Suitability

BABs are suitable for many investors as an alternative to other taxable bonds—especially investors in the lower tax brackets as well as tax-exempt investors, who are unable to take advantage of the tax-exempt features of traditional municipal bonds.

These bonds can be a tool for diversification in an overall portfolio.

The bonds have the security of 35% of the interest being paid by the federal government, and they are typically issued for the long term. The bonds are rated by credit agencies just like traditional municipal bonds.

Tax Implications

Like traditional municipal bonds, interest payments on BABs are exempt from local taxes in the state of issue.

However, interest is subject to federal taxes, not including the 35% tax credit for investors of the tax credit BABs.

The Pros

Higher Interest Rates

Due to the subsidy that issuers receive from the direct payment BABs, they are able to offer a higher rate of interest than they could otherwise afford.

Tax Subsidies

The tax credit BABs offer a 35% tax credit to investors.

The Cons

Hard to Purchase

Most of these bonds have been highly popular and have sold out very quickly to institutional investors. This makes it hard for individuals to get in on the action from the starting block. Bonds can be purchased in the secondary market, but you may have to pay a premium.

Liquidity

Although these bonds trade in the secondary market, they tend to be less liquid than corporate, treasury and traditional municipal bonds.

Call Risk

There is a slight risk that the federal government might eliminate or reduce the subsidies for BABs in the future. Some issuers are including provisions that allow them to call the bonds back and refinance if the federal government stops paying the interest rate subsidy.

Interest Rate Risk

As with any bond investment, there is always a risk that interest rate changes will affect bond prices. As interest rates rise, the price of the bond will fall. This affects investors who might want to sell bonds before they reach maturity.

Credit Risk

Just because the federal government is offering a subsidy, it does not mean it is backing the BABs. The municipality is the sole provider of the bond and bears the entire responsibility of repaying the bond and making interest payments. If the state or city goes insolvent, there is no guarantee on your bond.

Additional Information

InvestinginBonds.com
www.investinginbonds.com

InvestinginBonds.com is a Web site that provides information about various types of bond investments. The site is run by the SIFMA.

You can learn more about these bonds by choosing “Types of Bonds” from the Learn More section, and then selecting Build America Bonds from the list in the left-hand column. At the bottom of the page is a link to a PDF with issue data on the most recent quarter.


 

Cara Scatizzi is a former associate financial analyst at AAII.


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