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As credit markets froze up in 2008, the ability to raise capital (through debt) for even the most creditworthy institutions, such as state governments, municipalities, and blue-chip companies, became deeply constrained.  Though many of these entities possessed the wherewithal to service additional debt for working capital needs or infrastructure projects, investors seemed to eschew any credit instruments except for risk-free, Treasury bonds.  This created somewhat of a paradox for high-grade borrowers. Due to the strong concerns over the health of the credit markets, debt spreads were at historically wide levels, making it very expensive, perhaps unjustifiably, for even AAA-rated issuers to borrow money.  On the other hand, the deprivation of credit left a lot of municipalities strapped for cash to finance day-to-day operations, let alone to pay for large-scale, long-term projects.  In response, the Federal government enacted an innovative approach to attempt to both thaw municipal credit lines and stimulate the economy.

In April of last year, as part of the American Recovery and Reinvestment Act, the U.S. government unveiled the Build America Bond plan. Under the new program, state and local governments became authorized to issue taxable bonds, referred to as “Build America Bonds” (BABs), until the end of 2010 to finance any capital expenditure that could otherwise be financed through traditional, tax-exempt governmental bonds.  According to a press release from the Internal Revenue Service, “state and local governments receive a direct federal subsidy payment for a portion of their borrowing costs…equal to 35 percent of the total coupon interest paid to investors”. The aim of the subsidy is to assist governmental entities in financing capital projects by lowering borrowing costs, which, in theory, should also help in stimulating the economy and creating jobs. Unlike traditional municipal bonds, BABs are not guaranteed and are usually linked to a specific, capital-intensive project, such as roads, bridges, and school construction.

In effect, by the federal government fronting a portion of the interest payments tied to local-government debt, municipalities can afford to issue bonds at loftier coupons, which bolster investors’ appetite for the bonds.  In some instances, due to the government subsidy, BABs have been issued offering yields in excess of 6%; a very generous payout given credit-risk ratings that usually range from A to AAA.  These notes differ from typical municipal bonds in that they are taxable for retail investors, which means individual investors must pay taxes on the coupon payments as though they were income.  BABs tend to hold more appeal for institutional investors with tax-exempt status, such as pension funds, non-profit groups, and educational endowments, as they can utilize the amplified payments without the tax constraints.  In most cases, for individual investors, traditional municipal bonds will offer a better return on investment relative to risk, net of taxes.  Additionally, BABs are usually longer in duration (20-30 years) than the average municipal note and are generally less illiquid, which can create asset/liability mismatches for many individual investors.  However, someone possessing both a Roth IRA account (no tax implications) and a long-term investment horizon may find BABs to be an asset class worth examining.

Ironically, this program was rolled out just as confidence began to reenter the fixed-income markets.  During the second and third quarter of last year, credit spreads contracted at dizzying rates as investor appetite for risk returned swiftly.  Since risk-premiums had dropped so dramatically by the fourth quarter of 2009, institutional investors began to encounter difficulties finding good sources of risk-adjusted yield.  BABs have become an enormously popular asset class for tax-exempt investors as of late, due to the generous, taxpayer-enhanced yield, along with the good credit standing of many local governments.  Though the plan is set to expire at the end of this year and no explicit cap had been set for how many issuances or how much “muni” debt the government will sponsor, there may be pressure from municipalities and institutional investors alike to extend the program.  Speculation that issuance will continue indefinitely has been evidenced and fueled by the advent of investment funds solely devoted to investing in BABs.  In November of last year, asset manager Eaton Vance (EV) unveiled the first BAB mutual fund, the Eaton Vance Build America Bond Fund (EBABX).  For those looking for passive exposure to taxable municipal debt, Invesco Ltd. started the PowerShares Build America Bond Exchange-Traded Fund (BAB).  For the majority of individuals interested in investing in BABs, these types of vehicles would likely be the most suitable option.

This initiative is likely to become increasingly controversial if extended as more scrutiny is given to line items on the federal budget due to rising ire and concern over the nation’s fiscal deficit and debt figures.  The plan has been undoubtedly successful in raising capital and freeing up credit for local government, but the cost of the subsidy is already very expensive and will continue to grow if the initiative is not discontinued at its planned date.  Questions may already be looming about the lasting efficacy of the plan, given the contraction in credit spreads and the fact that the national unemployment rate lingering at close to 10%.