Build America Bonds

by Doug on Sep.08, 2009, under Fixed Income

Municipal bonds without the tax break.

Subsidies to municipal bonds so issuers can offer them at a lower rate…good for the issuer, bad for the bond holder. The worst part is they are taxable bonds. The BABs can generate an unpleasant surprise if you are holding a municipal bond fund as they will generate a tax liability.

The description of the bonds are:

The Economic Recovery and Reinvestment Act (the “Act”) created a new form of bonds known as Build America Bonds (“BABs”). Build America Bonds are taxable and, through Federal subsidies or tax credits, are intended to reduce municipal borrowing costs.

There are two kinds of bonds:

The first type of BABs provide a Federal subsidy to investors equal to 35% of the interest payable by the issuer (“Tax Credit BABs”).
The second type of BABs provide a direct Federal subsidy that will be paid to state and local governments in an amount equal to 35% of the interest (“Direct Payment BABs”).

Both types of BABs must be issued before January 1, 2011.

Potential investors of BABs include investors in low income tax brackets, individual retirement accounts, public pension funds and foreign investors.

Part of the American Recovery and Reinvestment Act, Build America Bonds offer a 35% rebate from the Federal government to issuers on their interest payments. This means that issuers can offer higher rates on their debt than they typically would be able to afford, and so take their offerings into the taxable bond market.

Guess where the 35% subsidy comes from? The taxpayers.

What is it costing the taxpayers?

Congress’s Joint Tax Committee estimated in February that the Treasury would spend $9.8 billion through 2019 subsidizing the bonds. Matt Fabian, a managing director at Municipal Market Advisors in Westport, Connecticut, said in a June 22 report that the program’s price tag may reach $27.3 billion by the time all such securities mature in 2044.