BABs: Beautiful If You’re Not Rich

March 10, 2010

Despite the Wall Street Journal’s worries about Build America Bonds, they can be great for your portfolio, especially if you’re not super-wealthy.

The Journal is out today with an article on the growing market for—and criticism of—Build America Bonds. BABs, as they are known, are a special type of municipal bond created last April as part of the federal stimulus effort. They are designed to help municipalities raise money to invest in infrastructure projects. Wall Street firms have earned more than $1 billion selling $78 billion in BABs, the Journal said.

The way they work is simple: Unlike traditional municipal bonds, these bonds are taxable. To offset the tax hit, the Federal government pays a 35 percent subsidy on the interest payment. For instance, if my great state of
were to issue a BAB paying 6 percent interest, the federal government would cover 2.1 percent of that interest payment.

In essence, BABs allow municipalities to offer bonds to the taxable market without paying out more in interest than they would on tax-free bonds. That’s a good deal for municipalities because the size of the tax-free bond market is limited, and BABs open up an entirely new avenue for sales.

To date, most investors have been interested in BABs because they were initially priced at extremely attractive rates. Even today, the PowerShares Build America Bond Portfolio (NYSEArca: BAB) ETF is paying a 5.31 percent 30-day SEC yield, which compares favorably to various other non-BAB bond ETFs. You can earn 4.03 percent on the iShares Barclays Credit Bond ETF (NYSEArca: CFT), 4.32 percent for the PowerShares Insured National Municipal Bond Portfolio (NYSEArca: PZA) and a measly 1.78 percent on the iShares Barclays Aggregate Bond ETF (NYSEArca: AGG). Given that the historical default rates on municipal debt are much lower than corporate debt (and more or less on par with the Aggregate), the higher payouts are attractive.

One overlooked benefit of BABs is that they make municipal debt relevant for people who are not super-wealthy (people like me). After all, the lower your tax rate, the less valuable the tax-free status is.


2009 Income Tax Brackets
Income Bracket Tax Rate
$0 - $16,700 0%
$16,700 - $67,900 15%
$67,900 - $137,050 25%
$137,050 - $208,850 28%
$208,850 - $372,950 33%
$372,950 - Above 35%


With BABs, the federal government applies the 35 percent interest rate kicker regardless of your tax bracket. That means, all else being equal, anyone earning less than $372,950 is likely to be better off buying BAB or individual BAB bonds than plowing money into actual municipal debt.

There are a thousand caveats to that statement, of course. Liquidity in individual BABs is limited, although the BAB ETF trades fairly well. More importantly, BABs and the BAB ETF can be much more volatile than broad-based muni bonds. Since inception in November 2009, the BAB ETF has underperformed most broad-based muni bond ETFs on a total return basis by more than 2 percent, as that volatility has taken its toll.

Still, given that it’s paying out more than 1 percent per year in higher yields than competing muni bond ETFs, it could be attractive for investors.

The current BAB program is set to expire in 2010, although existing bonds and interest subsidies will continue, and the change should not impact the ETF. The Obama administration is looking to expand the program indefinitely, although it plans to bring the interest rate subsidy down to 28 percent. That could lower the average yield on an ETF like BAB a smidge. Still, for most investors, it will remain a pretty nice deal.


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