Build America Bonds

In 2009, BABs offered an average yield of 3.69 percent. The federal subsidy brought down the cost of borrowing for states and local governments to 2.32 percent.

Build America Bonds (BAB) -- a new and federally subsidized form of municipal financing -- assist state and local governments to finance capital projects. Created as part of the 2009 American Recovery and Reinvestment Act, BABs were first used by the University of Virginia in April 2009. By the end of that year, some $63.4 billion in BABs had been issued. Unlike traditional municipal bonds, which pay interest that is exempt from federal income taxation, the interest on BABs is taxable. What makes them attractive to municipal issuers is that the federal government subsidizes 35 percent of the interest. For example, if a state or city issues a bond that pays 5 percent interest, it pays only 3.25 percent -- the balance, 1.75 percent, is paid by the federal government. The federal subsidy lasts for the life of the bond, although BABs can only be issued in 2009 and 2010.

Although individual investors traditionally have provided the bulk of municipal financing, the after tax yields on BABs are lower than the yields on municipal bonds for these investors. Therefore, BABs are attracting a new class of investors to municipal financing. In a recent NBER study, Build America Bonds (NBER Working Paper No. 16008), authors Andrew Ang, Vineer Bhansali, and Yuhang Xing conclude that: "the BAB program can be interpreted as a wealth transfer from the natural holders of municipal bonds, who are individual U.S. taxpayers, to corporations, pension funds, and foreign investors not subject to individual U.S. income taxes."

The interest rates on BABs make them attractive to such non-taxable investors as pension funds: they get the full return and owe no taxes. In 2009, BABs offered an average yield of 3.69 percent. The federal subsidy thus brought down the cost of borrowing for states and local governments to 2.32 percent, on average. The authors estimate that if these issuers had issued equivalent municipal bonds, they would have had to pay 2.86 percent on average, or an extra 54 basis points per year.

The yields on BABs not only exceed those on traditional municipal bonds from the standpoint of tax-exempt investors, they also exceed the yields on Treasury securities: on average, 3.69 percent versus 2.53 percent -- a 116 basis point advantage. Some of that difference involves differing risk factors: municipal bonds are seen to have higher risk than Treasuries and thus, investors demand a higher premium. For individual investors in the top tax bracket, however, while the after tax yields on BABs also exceed Treasuries, they fall below the after tax yields on traditional municipal bonds.

-- Laurent Belsie