Build America Bonds: Should You Buy?

by James E. McWhinney (Contact Author | Biography)

Email Article

Feedback

Reprints

Filed Under: Bonds, Debt, Economy, Personal Finance, Recession

Build America Bonds (BABs), which were included in the American Recovery and Reinvestment Act signed into law by President Obama on February 17, 2009, made their debut in April of the same year. Stevens Point Wisconsin was first out of the gate, selling $3,650,000 worth. By the end of the month, the New Jersey Turnpike Authority sold $1.32 billion, the state of California sold $5.2 billion, and other governments, including New York and Minnesota, were bringing their offerings to market.

Meet BABs
BABs are a new form of government bond which can be used in a variety of ways. Like municipal bonds, they are debt securities issued by a state, municipality or county to finance its capital expenditures. Unlike municipal bonds, the income they generate is taxable. There are two general types of BABs.

In the first version, BAB issuers receive a subsidy from the federal government equal to 35% of the interest paid to investors for purchasing the bonds. This permits government entities to issue bonds that pay interest rates that are competitive with the rates paid by corporations. California's massive issue in early 2009, for example, offered an interest rate of 7.4% to investors. The state, courtesy of the tax break, had to pay only 4.8% of that interest, with the federal government picking up the tab for the rest.

In the second version, BAB holders receive a tax credit from the federal government equal to 35% of the interest on the bond each year. If the bondholder's tax liability is insufficient to use the entire credit, it can be carried forward to future years. (If you're not taking advantage of these deductions, you could be missing out on tax savings, read Tax Credits You Shouldn't Miss and Give Your Taxes Some Credit.)

The first variety has proven to be the most popular. Its tax structure, with the credit going to the issuer, makes the bonds attractive to entities that pay no

U.S.

income taxes (think pension plans and foreign investors) as well as to investors seeking high rates of interest income. In all cases, the BABs make it easier and less expensive for government agencies, such as local and state governments, to borrow money - which is the objective of the program. The United States government will support BAB offerings for the remainder of 2009 and all of 2010. (Learn more in The Basics Of Municipal Bonds.)

Get 'Em If You Can
BABs have been a big hit in the market place, with every issue oversubscribed - meaning there were more buyers than bonds. The New Jersey Turnpike Authority offering was so popular that instead of issuing $250 million in bonds, $1.32 billion was issued. Clearly, with numbers like those, large institutional investors are behind the buying.

This is no surprise. Traditionally, individual investors drive much of the traffic in the municipal bond market. Tight credit markets have forced municipalities to offer higher interest rates to attract buyers. Couple this with the fact that institutional investors are seeking stable, long-term sources of income, the fact that BABs are being issued in long denominations (California's issue was a 30-year bond) and that issues are not offering a period of time set aside for what are known as "retail" orders, and institutional investors are able to buy up the bonds. Since every issue has been oversubscribed, there are none left for the retail market.

How does the little guy get involved? There are two opportunities for retail investors to get a chance to buy BABs. The first is in the secondary market. After their original issuance, BABs trade just like other bonds. You may pay a premium, but you can probably get what you want.

The second is by focusing on smaller issues. While the state of California attracted massive amounts of media coverage and attention from institutional investors, not all issuers are so large, and BABs won't be new forever. When future issues come to market from smaller issuers, it is likely that retail investor will get their shot. The question is, should you? (Learn more in our Bond Basics Tutorial.)

Risks and Realities
BABs are a new offering, so there isn't a huge market of buyers and sellers for them the way there is for common stock, which could limit their liquidity. While their current popularity may overcome liquidity concerns, the current crop tend to have maturities that are decades away. If your time horizon in 30 years, and a steady source of income is what you are after, BABs may fit the bill.

On the other hand, the issuers must remain solvent to make their payments to you. Similarly, the federal government must remain solvent in order to make that subsidy payment to the issuer. The latest predictions suggests that Social Security, Medicare and interest on U.S. debt payments are going make that a tall order for the U.S. Treasury sometime before 2030.

The Bottom Line
Risk aside, in their current incarnation, BABs are built for institutional investors. Retail investors have access to buying them, but before you do, make sure you have a solid understanding of what you are buying and a good reason for buying it.

by James E. McWhinney (Contact Author | Biography)

James McWhinney has been a professional writer for nearly two decades. He has worked for many of the nation's top mutual fund providers and banks in addition to numerous magazines, websites and other publications. He specializes in financial services and travel.

Filed Under: Bonds, Debt, Economy, Personal Finance, Recession

Rate this Article: Your Rating: Overall Rating: Vote Now!