Build America Bonds: Should You Buy?

By James E. McWhinney AAA

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 had 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. So just what are these bonds you keep hearing about, and should you buy them?

Tutorial: Bond Basics

What are BABs?
BABs, like municipal bonds, are debt securities issued by a state, municipality or county to finance 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 that 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 for more information)

The first variety has proved 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. (Learn more in The Basics Of Municipal Bonds.)

How to Buy BABs
BABs were a big hit when they first hit the market, and every issue during the first year was oversubscribed; in other words, 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 were behind the buying.

This is no surprise. Traditionally, individual investors drive much of the traffic in the municipal bond market, but things were a bit different with BABs, where unusually tight credit markets forced municipalities to offer higher interest rates to attract buyers. Higher rates, the fact that institutional investors were seeking stable, long-term sources of income and the long denominations (20- to 30-year terms) on BABs combined to make these attractive to institutional buyers. Plus, because issuers did not offer a period of time set aside for what are known as "retail" orders, institutional investors are able to buy up all of the bonds when they first hit the market.

So how does the little guy get involved? There are multiple opportunities for retail investors to buy BABs. One way 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 big issuers like the state of California attract massive amounts of media coverage and attention from institutional investors, not all issuers are large, and BABs won't be new forever. When future issues come to market from smaller issuers, retail investors may have an opportunity to buy. Even if they don't, there are still others ways to get BABs.

Mutual funds provide multiple opportunities to add BABs exposure to your portfolio. Some funds, such as the Eaton Vance Build America Bond Fund (launched November 17, 2009), specialize in BABs, while other funds hold BABs as a percentage of their underlying holdings (often a small percentage). Exchanged traded funds also provide multiple opportunities to invest in BABs.

The Future of BABs
The BABs program was created to help municipalities raise cash during a credit crunch. Legislative changes will make new issuance via the program less attractive over time, and an eventual phase out of new issues is possible - and perhaps even likely. Even if that occurs, BABs will be with us for a long time to come in the secondary market, as existing securities won't mature for decades even if no new issues come to market. (Learn more in our Bond Basics Tutorial.)

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