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DEFINITION of 'Build America Bonds - BABs'

Build America Bonds (BAB) were taxable municipal bonds that featured tax credits and/or federal subsidies for bondholders and state and local government bond issuers. Build America Bonds (BABs) were introduced in 2009 as part of President Obama's American Recovery and Reinvestment Act (ARRA) to create jobs and stimulate the economy.

The Build America Bond program expired in 2010.

BREAKING DOWN 'Build America Bonds - BABs'

During the economic recession in 2009, investors were saving their money and staying away from investments, including municipal bonds. To ensure that local municipalities and counties were able to raise the much-needed capital needed to revitalize their local economies, the federal government introduced Build America Bonds (BABs).

BABs were introduced to encourage investment in the local sector. BABs, like municipal bonds, are debt securities issued by a state, municipality, or county to finance capital expenditures. The interest rate on these bonds were subsidized by the federal government, making the cost of borrowing for infrastructure projects cheaper for state and local governments looking to borrow funds to finance new projects. In general, there are two distinct types of BABs: tax credit BABs and direct payment BABs.

Tax credit BABs offered bondholders and lenders a 35% federal subsidy of the interest paid through refundable tax credits, reducing the bondholder’s tax liability. If the bondholder's tax liability was insufficient to use the entire credit, it could be carried forward to future years.

The direct payment BABs offered a similar subsidy that was paid to the bond issuer. The U.S. Treasury made a direct payment to Build America Bond issuers in the form of a 35% subsidy of the interest they owed to investors. Since the effective cost of borrowing was reduced for issuers, they were able to offer the bonds to investors at competitive rates in the markets. California's $5.2 billion BAB issue in early 2009, for example, offered an interest rate of 7.4% to investors. The state had to pay only 4.8% of that interest, with the federal government picking up the tab for the rest. In addition, investors were more likely to opt for a bond issued by a government body since they will be less exposed to default risk prevalent in holding corporate bonds.

The difference between Build America Bonds and traditional municipal bonds is that income generated from the latter is exempt from federal and some state taxes while with BABs, the interest income was subject to tax at the federal level. Some traditionally tax-exempt issuers, such as private party issuers and 501(c)(3) organizations, were not eligible to use the Build America Bond program. Also, the program was only open to new issue capital expenditure bonds issued before January 1, 2011; BABs could not be issued for refinancing transactions.

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