Build America Bonds (BABs) are a relatively new form of taxable municipal bonds created under the American Recovery and Reinvestment Act of 2009. They are designed to subsidize state and local government projects that otherwise might be unaffordable, and generally help stimulate the economy.
There are two types of BABs, "Direct Payment" and "Tax Credit.” Direct Payment BABs provide the federal subsidy directly to the issuer, while Tax Credit BABs provide the federal subsidy as a refundable tax credit directly to the bondholder.
To reduce the cost of borrowing for eligible state and local government issuers and governmental agencies, these entities receive a direct subsidy from the federal government of 35% of the BAB coupon. This, in turn, enables the issuers to offer higher interest rates that can make BABs attractive to both institutional and individual investors.
Unlike owners of tax-free municipals, holders of Build America Bonds are subject to federal income tax on the interest they receive. However, holders who live in the state where the bond was issued may be exempt from state and local taxes on the interest. BABS cannot be used for refunding working capital, private activities, or 501(c)(3) organizations. BABS are often issued by essential services providers, such as water and power agencies, which may mean that a reliable income stream is available to cover the interest payments. Most BABs have been issued with maturities of more than 20 years.
As with all bonds, BABs carry the risk of default. However, municipal default rates historically have been significantly lower than default rates in the corporate bond market. When defaults have occurred, the average recovery rate on municipal bonds has been higher than on defaulted corporate bonds. BABs that have been issued thus far generally have received investment-grade ratings from rating agencies.
The BABs program expired at the end of 2010, and proposals to extend it have not been approved by Congress.
Build America Bonds are issued pursuant to the American Recovery and Reinvestment Act of 2009 that authorizes state and local governments to issue a taxable governmental bond with federal subsidies to the issuer for a portion of the borrowing costs. This subsidy does not constitute a federal guarantee of payment to the bondholder. Municipal Bonds Risk: Municipal bonds are fixed rate debt obligations that generally decline in value with increases in interest rates, an issuer’s or an insurer’s worsening financial condition or a drop in bond ratings. Typically, bonds with longer periods before maturity are more sensitive to interest rate changes. Build America Bonds, unlike traditional municipal bonds, are taxable. Build America Bonds Risk: Any issuer of a Build America Bond that fails to continue to meet the requirements imposed by the American Recovery and Reinvestment Act of 2009 may not receive federal cash subsidy payments which could impair its ability to make scheduled interest payments. These securities may also carry extraordinary calls which cannot be predicted and thus the yield cannot be calculated. Tax Treatment Risk: Changes in the tax treatment of bonds either due to future legislation or due to the failure of a public issuer of a bond (or private guarantor) to meet certain conditions imposed by various tax laws may have an adverse impact on the value of the bonds. Past performance is not indicative of future results.