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.
The PowerShares ETF has an effective duration of 8.75 years, with an average maturity of 19.81 years. The ETF also has a heavy tilt toward California and Illinois issued debt.
BAB comes with a 4.01% 30-day SEC yield, but the bonds are not tax-exempt on the federal level.
Alternatively, investors can consider the SPDR Nuveen Barclays Build America Bond ETF (NYSEArca: BABS). However, BABS is smaller, more thinly traded and comes with a longer duration of 12.5 years. The ETF has a 3.91% 30-day SEC yield.
For more information on the munis market, visit our municipal bonds category.
Max Chen 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.