August 24, 2010
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A skeptical attitude toward new products has long served the best interests of advisors and their clients, almost without fail. Advisors, however, should not be afraid to embrace one of the market’s most prominent recent innovations: the Build America Bond (BAB).
While BABs are different from traditional tax-exempt municipal bonds, they are still issued by the same state and local governments. Because they are new, they yield more than either agency or corporate bonds. They are backed by a federal tax credit that gives them added support, and their many large issues provide market liquidity.
Before I explain the compelling features of BABs, let’s review the program under which they were issued to see exactly how they differ from corporate and traditional municipal bonds.
The BAB program, created by the American Recovery and Reinvestment Act (ARRA) of February 2009, permitted a federal subsidy of municipal borrowing to help alleviate the states’ great economic distress. Instead of issuing tax-exempt bonds, municipalities can now issue taxable municipal bonds and receive a federal cash subsidy equal to 35 percent of their interest costs for new projects only. Municipalities could issue as many bonds as they wanted in 2009 and 2010. Issuers have switched to now receive most of their funding from BABs, with maturities of 15 years and longer being the most common (because low rates in that portion of the yield curve offered the cheapest financing). In the first 16 months of the BAB program, states issued over $105 billion in BABs, or approximately 25 percent of the municipal new issue market.1
BABs opened up new markets for municipal debt. There was enough demand and liquidity to attract institutional buyers for multi-million-dollar deals. Most taxable bonds are long-dated, so BABs give insurance companies and pension funds the ability to match their long-term liabilities with their assets. Mutual funds and ETFs have also been big purchasers of BABs. Individual investors purchase the bonds through these vehicles and can also buy the bonds directly. The BABs are ideal for retirement funds, and they are a new taxable alternative for individuals in low marginal tax brackets.
BABs, which carry the partial backing of the U.S. Treasury, are taxable debt that should appeal to global buyers. Though foreign governments were wary of BABs initially, the near-implosion of Greek debt has since made these bonds much more attractive. 2
Short sellers who bet on the default of Greece and other sovereign nations’ bonds are now betting on the default of some states using credit default swaps (CDS). For a series of payments, the buyer gets face value of a bond in the event of a bond default. The CDSs have only deepened awareness of the need for change and adaptation, and they have not harmed BAB issuers by increasing bond yields. 3BABs are less risky than sovereign debt. According to Moody’s, the default rate on sovereign bonds since 1970 has been 6.36 percent, while the default rate on municipal general obligation bonds was 0.01 percent for the same period. 4 The recovery rate on defaulted municipal US debt is far superior to the recovery rate on sovereign bonds. For dollar-based investors, high-quality BABs are the obvious choice.
1 “Build America Bond Program,” RBC Wealth Management, June, 2010.
2 Dan Seymour, “BABs Beating the Rest: Munis Trump Sovereign Credits,” The Bond Buyer, May 28, 2010.
3 Joe Mysak. “Short Sellers Are Cutting Borrowing Costs of States,” Bloomberg.com, August 20, 2010.
4 Dan Seymour. “BABs Beating the Rest: Munis Trump Sovereign Credits,” The Bond Buyer, May 28, 2010.
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