Rising Rates, Sequestration Hit Build America Bond ETFs

June 20th at 12:10pm by Tom Lydon

It is not just U.S. junk bonds or emerging markets sovereign debt that have suffered at the hands of bond bubble chatter. Add Build America Bonds to that list as multiple factors explain the stunning retrenchment in Build America Bond ETFs over the past month.

In the past month, the PIMOC Build America Bond ETF (NYSEArca: BABZ) is down almost 6% while the PowerShares Build America Bond Portfolio (NYSEArca: BAB) has tumbled 7.1%. Those declines come after Build America Bonds have dodged assorted issues that could have been hazardous to the health of the asset class. Last year, Build America Bonds were seen as vulnerable during the fiscal cliff negotiations as some politicians pushed to end the program. That came after Build America Bonds were on the chopping block in late 2010 during tax talks. [Build America Bonds' Future in Question]

Now it is the pesky sequestration issue, among others weighing on Build America Bonds. Sequestration that started March means the government will make $85 billion in spending cuts for the fiscal year ending September 30. That includes reducing the originally promised 35% subsidy on Build America Bonds to about 32% for U.S. states, reports Brian Chappatta for Bloomberg.

Classified as municipal bonds, Build America Bonds were created as part of President Obama’s 2009 stimulus package. Although the original intent was to let the program expire in 2010, ETF issuers and investors embraced the asset class while knowing the program may never become permanent. President Obama has said he wants to make Build America Bonds permanent, but some Republicans oppose that effort. [Build America Bond ETFs Get Second Chance]

The popularity of Build America Bonds has been bolstered by what investors perceive as a low level of risk accompanied by enticing yields. For example, BAB has almost $980 million in assets under management and a 12-month trailing yield of nearly 5%.

However, Build America Bonds typically have long durations, making them vulnerable to rising interest rates. BAB has an effective duration of 10.64 years, according to PowerShares data.  That is more than double the effective duration on the iShares iBoxx $ High Yield Corporate Bond Fund (NYSEArca: HYG).

Of the $181 billion in total BAB debt issued, less than 10% of it has coupons under 4% and maturities less than ten years, according to JP Morgan.

What the near-term outlook for Build America Bonds boils down is to investors taking two-fold risk just to chase yield. Those risks being that interest rates will not rise and that these bonds can withstand government subsidy reductions. Recent price action in the ETFs highlight the suddenly elevated risk associated with a group of bonds investors did not expect to be this volatile.

PowerShares Build America Bond Portfolio

ETF Trends editorial team contributed to this article.

The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.

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