Build America Bonds and related exchange traded funds provide attractive yields and have outperformed other tax-exempt municipal bonds. However, these debt securities face greater risks in a rising rate environment.
The PowerShares Build America Bond Portfolio (NYSEArca: BAB) provides diversified market-cap-weighted exposure to U.S. dollar-denominated Build America Bonds issued by U.S. municipalities, writes Morningstar analyst Thomas Boccellari.
Build America Bonds are a type of taxable municipal bonds that were issued as part of the American Recovery and Reinvestment Act of 2009. The federal government originally subsidized 35% of the issuers’ interest cost but has since diminished the subsidy to 27.7% due to sequestration. Nevertheless, the bonds have still outperformed.
BAB is up 12.1% so far this year and has returned an average 7.2% over the past three years. In comparison, the iShares National AMT-Free Muni Bond ETF (NYSEArca: MUB) gained 7.4% year-to-date and returned 4.2% over the past three years.
Potential investors, though, should be aware that municipalities have stopped issuing new Build America Bonds after the program ended in 2011. Consequently, when rates rise, the fund would not be able to buy new issuance with higher interest rates to offset principal losses from its underlying holdings.
“Because of the lack of new bond issuances, the fund’s duration should decline over time, until bonds in the portfolio begin to mature,” Boccellari said.