Ah, the signs of summer: Detour, Right Lane Closed Ahead, Slow. Don't you love those bright orange barrels and the tangy scent of fresh asphalt? You would if you knew they were generating a check made payable to you every six months.
State and local governments are issuing Build America Bonds (BABs) to fund local infrastructure projects. If you buy these bonds it's like pocketing your own personal economic stimulus plan.
BABs have the entire package: high interest payments, relative safety and possible tax incentives, plus they are wrapped in patriotism helping to rebuild the economy. Build America Bonds are the supermodel of investments right now. Here's how you can make money from them.
Economic Stimulus Done Right
The American Recovery and Reinvestment Act of 2009 includes a provision to help state and local governments raise money for new projects by issuing taxable bonds. Taxable municipal bonds are not a new concept, except these bonds come with a 35% bond interest rebate from the Federal Government.
The rebate makes it cheaper for local governments to raise capital, so they pass the savings on to bond buyers in the form of higher interest rates. Municipal bond issuers can opt for a tax incentive for bond purchasers. (Investing in bonds - what are they, and do they belong in your portfolio? Read the Bond Basics Tutorial.)
Here's how it works. Your state needs to rebuild some bridges (literally), but they are strapped for cash because the lagging economy has sapped revenues. You loan the state money and they agree to pay you interest every six months for 20 or 30 years, then they pay back your initial lump sum.
Part of your interest payment comes from either the Federal Government rebate or a tax credit. You pay taxes on the interest payments but not on the lump sum. Your state has good credit (they've never defaulted on a loan), so you trust you will eventually get your investment back while you enjoy regular income in the meantime.
Spreading the Costs
All American tax payers are funding BAB rebates (including BAB buyers). The $50 billion allocated to the states is part of the Federal budget. BAB holders pay taxes on the interest from the bonds, but they pocket the after-tax amounts.
Build America Bonds give state and local municipalities a bigger market to fund projects. Folks may scoff at accumulating additional debt but, with interest rates still relatively low, now is the time to for municipalities to take advantage of low cost loans.
Local governments have to eventually pay back the loans, but revenue over the course of 30 years will usually generate the necessary amount due.
Who Should Buy BABs?
Traditionally, tax-free municipal bond holders were conservative investors in higher income tax brackets, looking for income. Muni bond holders are used to sacrificing lower interest rates for safety and lower taxes.
Corporate or taxable bond holders usually enjoy higher interest rates, but pay taxes on the income and endure greater risk. Build America Bonds are more like corporate bonds in that they are taxable with higher interest rates, but they are less risky.
Build America Bonds offer retirees safe, long-term income. Younger investors can add BABs to retirement accounts to defer taxes and offset more risky portfolio investments. All portfolios should be diversified to reduce risk and all investors should consider the tax consequences of their investments. (Knowing more about your taxes can generate a larger return. Check out Common Tax Questions Answered.)
Institutions are major buyers of municipal bonds. Your company's pension fund, the local hospital and the state university are likely BABs holders. It's a win-win for individuals because the financial stability of these organizations impacts their contributions to the community.
How Do You Find Them?
Bond issuers must apply for the special Build America Bond status on new bonds issued in 2009 and 2010. Brokerages associated with large investment banks, like Wells Fargo and Merrill Lynch, market new municipal bonds mostly in large amounts.
After municipal bonds are issued they are bought and sold by brokerage firms. You will still be able to purchase them after the original issue from brokerage firms that traditionally sell blocks of bonds to their clients. This is the best opportunity to purchase smaller amounts of BABs.
A good source of Build America Bonds is taxable bond funds. These mutual funds offer a variety of funds, which diversify the risks, but come with the added price of fund fees. Check the bond holdings lists for taxable municipal bonds. (Treasuries are considered the safest investments, but they should still be analyzed when issued, see Basics Of Federal Bond Issues.)