A New Kind of Bond in the Municipal Bond Market

The new Build America Bond Program allows state and local governments to issue taxable bonds in 2009 and 2010 for government capital projects and receive a direct federal subsidy payment from the US Treasury for a portion of their borrowing costs. Unlike municipal bonds which are usually tax exempt, Build America Bonds (BABs) are a new type of bond that pays interest which can be taxed; issuers can choose whether they offer a tax credit for the buyer or a direct payment from the federal government equal to 35 percent of the interest costs. Because of strains in the municipal market due to the economic downturn, these new BABs have been popular with issuers and institutional investors alike.

Build America Bonds are intended to help state and local governments finance capital projects at a lower cost because the federal government is subsidizing the interest paid in the amount of 35 percent, stimulate the economy and create jobs. Government capital projects refer to creating public infrastructure such as public schools, roads, transportation infrastructure such as rail, bridges and ports, public buildings, etc. BABs are only for governmental activity not private activity bonds, that is, the proceeds of such bonds cannot be used by for-profit or not-for-profit organizations. BAB issuers can offer higher interest rate payments than typically they would be able to afford because of the federal government subsidy. This helps state and local government issuers potentially issue bonds that are more attractive to investors which would normally be interested in the corporate bond markets.

The BABs program expired at the end of 2010. However, President Obama’s fiscal 2012 budget, which he released on February 14, 2011, proposes to permanently reinstate the Build America Bonds (BABs) program with lower, revenue neutral, 28 percent subsidy rate. The BABs program, which were created by the American Recovery and Reinvestment Act of 2009 and expired on December 31, 2010, originally provided a 35 percent federal reimbursement of interest costs, but they could only be used for general obligation (GO) infrastructure projects. The president’s proposal would allow 501(c)(3) nonprofit issuers to sell BABs and expands their use to current refunding and short-term working capital. The House and Senate will consider the proposal and it is unclear whether BABs will be included in any budget to which Congress agrees.

Build America Bonds (Direct Payment) are bonds in which the U.S. Treasury Department pays state or local government issuers a payment equal to 35 percent of the coupon interest payments on such bonds. Proceeds of these bonds can be used for expenditures, debt service reserve funds and costs of issuing the bonds but not to refinance capital expenditures, so-called refunding issues. The 35 percent U.S. Federal interest subsidy is deeper than the corresponding 25 percent Federal interest subsidy on Build America Bonds (Tax Credit). Fixed-rate and variable-rate bonds can be issued under this program.

Build America Bonds may attract additional bond investors — including foreign investors such as foreign banks and pension funds — that might have previously been interested only in Treasury, agency or corporate bonds. Pricing is likely to be somewhere between a comparable corporate bond and the tax-equivalent yield of a municipal bond. Most BABs are issued for debt of twenty years and longer.

An investor will be purchasing a taxable bond whose interest rates are partially subsidized by the U.S. Government. This can help diversify a portfolio with bonds that have the security of 35 percent of the interest being paid by the federal government; are issued for long term; could provide yield benefit over other bonds in some cases; and in general are considered more secure than conventional municipal bonds with lower default rates than comparable corporate bonds. Some investors may also choose to invest in BABs because they are financing public infrastructure such as roads, bridges and schools.

Institutional investors, such as pension plans, money managers and mutual funds, are purchasing BABs due to their long term nature and for situations where they do not need tax-exempt income.

Individual investors who might be considering these bonds should understand that BABs are new and complex instruments, are not conventional municipal bonds and are not as liquid as municipal bonds. These bonds might be considered for part of an individual investor’s buy and hold strategy if they hold bonds for maturities of 20 years and longer. (Longer term bonds have to pay more interest because their longer term brings more risk to investors.) Like traditional municipal bonds, interest payments to investors in BABs are exempt from local taxes in the state of issue; unlike conventional municipal bonds, however, interest on BABs may be subject to federal taxes. Individual investors should consult their financial or investment advisers for more information to determine whether these investments are appropriate for their particular circumstances.

Build America Bonds can be issued in 2009 and 2010, i.e. the bonds must be sold in the next two years.There is no cap on the number of BABs that can be sold and there is no cap on the amount the US Treasury will pay in subsidies.

There are some issues that are still to be worked out including how to price these bonds daily over time; how to use taxable conventions in a state and local municipal tax exempt bond framework and whether BABs will be sold after 2010.

Liquidity risk — As a new kind of bond offering, the market of buyers and sellers for BABs is also new. There is a risk that not enough interested buyers will be available to permit an investor to sell at or near the current market price.
Interest rate risk — The risk that interest rates might change affects BABs. For example, if interest rates rise, BAB market prices might fall.

Call risk — Some (mostly larger) BAB issues have conformed to the convention in the corporate bond market of either requiring what is called a make-whole call premium or not having an option of being redeemable. Some have been issued with provisions that allow state and local governments to “call” the bonds back and refinance if the federal government stops paying subsidy on the interest. Investors should understand what call provisions exist on the BAB issue they are considering. Note that there is only call risk for the investor if the BAB being considered has a call provision.

Credit risk — This is the risk that an issuer will default or be unable to make payments. The credit of the bond is backed by the municipality issuing the bond, not the federal government. The issuer of the bond must remain solvent in order to pay investors.

Federal subsidy risk — There is the risk that the federal government would eliminate or reduce the subsidies for BABs in the future. Some BABs have been issued with provisions that allow state and local governments to “call” the bonds back and refinance them if the federal government stops paying subsidy on the interest.

Due to the success of Build America Bonds, the program’s features have been passed on to more municipal issuers. Certain types of tax credit bonds issued after March 18, 2010, are now eligible to receive direct subsidy payments from the U.S. Treasury to help with a portion of their borrowing costs. Issuers of four types of credit bonds-issuers of qualified school construction bonds, qualified zone academy bonds, new clean renewable energy bonds and qualified energy conservation bonds-can opt to receive direct subsidies instead of offering tax credits to investors.

Eligible issuers of school construction bonds and zone academy bonds can receive payments equal to the lesser of the actual interest rate of the bonds or the tax credit rate for municipal tax-credit bonds, which the Treasury sets daily.

Eligible issuers of energy bonds can elect to receive direct payments equal to 70 percent of the amount of interest that would have been payable under the tax-credit option.

Turning tax credit bonds into BAB-style bonds is intended to make them more attractive to issuers, helping state

For the latest SIFMA research and statistics on Build America Bonds click link below.

SIFMA Fact Sheet About Build America Bonds