Build America Muni Bond ETFs Hot For Now

April 10, 2014

BABs Tutorial

Let’s take a step back for a moment to define what exactly BABs are and how their unique market structure works.

Created after the financial crisis when many localities were having difficulties securing financing at reasonable costs, the BABS program subsidized localities to help them reduce their borrowing costs for various “shovel-ready” infrastructure projects.

There are two types of BABs—tax credit; and direct payment. The direct payment BABs provide federal subsidies on the interest expenses to the issuer. The tax credit BABs provide tax credit directly to bondholders.

BABs differ from conventional muni bonds in one key way: callability, which is to say, most BABs aren’t callable.

Convexity measures the sensitivity of duration to changes in interest rates. With embedded callability options, many conventional muni bonds have lower convexities, and even negative convexities—prices drop when benchmark yields drop—at times in the low-yield area of the diagram below. It’s intuitive that issuers might call away bonds with higher coupons and issue new bonds at a lower rate.

The price of a bond with a call option and negative convexity might actually drop when yields drop, because investors expect the issuer might simply call away the bond.


BABs Not Callable

Unlike conventional muni bonds, most BABs are not callable, resulting in higher convexities.

Bonds with higher convexities will react more violently to interest-rate changes in a low-rate environment, while the opposite is true for bonds with lower convexities in a high-rate environment. Given the current ultra-low-rate environment, bonds with high convexities will see wider price swings——up or down—as interest rates change.

BABs with the same duration but greater convexity than their callable muni counterparts will be more sensitive to interest-rate changes. This explains why BABs performed so poorly in 2013 as yields on benchmark 10-year Treasury notes rose somewhat sharply after Bernanke’s tapering comments.


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