In anticipation of the end of Bush-era tax cuts, investors are considering the tax shelter offered by municipal bonds and related exchange traded funds (ETFs). One of the more interesting products to come out of the financial crisis is the Build America Bond ETF, which give investors a direct way to play the recovery of the domestic economy.
What Are BABs?
The Build America Bond program was created to help ease the liquidity crisis found in the bond markets after the financial crisis had wreaked havoc. When a state or local government issues a Build America Bond, it receives a cash subsidy from the federal government equal to 35% of the coupon interest rate on the bond. Interest payments are subsidized by the U.S. Treasury, making them attractive to cash-strapped municipalities and states. Yields are comparable to those found in corporate bonds.
More than $125 billion in Build America Bonds has been issued. The appeal is easy to see: interest rates are declining and Bush tax cuts are expiring, and it’s all contributing to a rush for tax-free municipal debt.
Build America Bonds have been so popular, in fact, that demand has outpaced supply – they’ve accounted for 21% of all municipal bond issuances since April 2009. The credit-strapped markets pushed municipalities to hike up their interest rates to attract buyers, and the buyers flocked to the high yields.
The Build America Bond program was originally scheduled to end this year. But there could be a savior to the program coming: The Investing In American Jobs and Closing Tax Loopholes Act — HR 5893 — would extend BABs for two years. Also, the legislation would gradually reduce the subsidy rate for BABs from the current 35% level to 32% for bonds sold in 2011, and 30% for those sold in 2012. BABS come in a range of maturities, from 1-5 years on up to more than 25 years.
This legislation is currently working its way through Congress.
BAB Risks
Like any investment out there, Build America Bonds do have some risks you should heed:
- If the program does end as scheduled on Dec. 31, 2010, the number available in the marketplace will be limited and may negatively affect the value of the bonds.
- Liquidity may be an issue since the nascent market does not have a large pool of buyers and sellers to draw upon. However, this program’s growing popularity and an extension may ultimately remedy that.
- Current BABs are only offered with maturities that are decades in the future. Investors seeking a steady stream of income with a longer time horizon may consider this investment class.
- Additionally, these bonds are subject to the general risks and rewards as seen by municipal bonds – namely, the risk of default.
Given the newness of the BAB program, there are just a few BAB ETFs trading right now and an additional one currently in registration.