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Worried About Munis? Turn to Build America Bond ETFs

Build America Bonds are altering the municipal-bond market.

Timothy Strauts, 08/30/2010

First issued in April 2009, Build America Bonds are a relatively new type of municipal bond stemming from the American Recovery and Reinvestment Act. This new bond type is changing the dynamics of the municipal-bond market because Build America Bonds pay taxable interest, unlike normal municipals, which pay federally tax-free interest.

In the depths of the financial crisis, liquidity was impaired in the municipal-bond market. Prices were severely distorted as there were many times more sellers than buyers. The Build America Bond program was created to help ease this liquidity crisis. When a state or local government issues a Build America Bond, it receives a cash subsidy from the federal government equal to 35% of the coupon interest rate on the bond. These payments can make the costs to the municipality lower than those of traditional federally tax-free bonds. A municipality that can offer both types of municipals may be able to offer a tax-free bond at a 4% interest rate and a Build America Bond at a 5.5% interest rate. With the Build America Bond, the municipality will, in this case, receive a cash payment equal to 1.925% from the federal government. The subsidy reduces the effective interest rate for the municipality to 3.575%. This interest-rate advantage has made the Build America Bond program hugely successful.

Over $125 billion in Build America Bonds have been issued. In a period of declining interest rates and speculation that the Bush tax cuts will be allowed to expire, the demand for tax-free municipal debt has been high. Build America Bonds have taken up 21% of all municipal-bond issuance since April 2009. This has created a situation where tax-free municipals have more demand and less supply, causing prices to rise and interest rates to fall.

While build America Bonds have been a very successful program, there have been a few speed bumps along the way. Investment banks initially charged more to underwrite Build America Bonds then traditional tax-free municipals, but these initially higher rates have come down as investors have become more comfortable with the new structure. There has also been concern from municipalities that they might not receive their interest-rate subsidy from the Treasury Department. If the municipality owes the IRS payroll taxes, the subsidy is reduced by the amount owed. Data has shown that only 1% of municipalities have had any trouble receiving their payments. Furthermore, the problems that did arise have usually been cleared up relatively quickly.

PowerShares Build America Bond BAB and SPDR Nuveen Barclays Build America Bond BABS are the two easy ways to get access to Build America Bonds. BAB was released first and has over $500 million in assets, which is substantially more then the BABS total of $15 million. The two ETFs have very similar portfolios, so we think investors should focus on BAB because of its greater liquidity. Issuers have been releasing mostly long-term bonds because the interest-rate subsidy in Build America Bonds gets more advantageous as the term of the bond increases. This overissuance of long-term debt has made the average maturity of BAB 22.5 years, making it very susceptible to interest-rate movements. Municipalities have been having fiscal problems, but the average credit quality of both ETFs is still AA. Build America Bonds compete directly with corporate bonds in investor portfolios. Currently, Build America Bonds have higher yields then those of comparable-maturity corporate bonds. The reason for the higher yields is uncertainty over the continued issuance of new bonds beyond 2010.

The Build America Bond program is set to expire at the end of this year. The Obama administration has proposed that the program be made permanent, and the interest rate subsidy be reduced to 28%. The goal of the reduced subsidy is to make it revenue-neutral--the amount the federal government pays out in subsidies will be collected in taxes on the interest investors receive. The federal government prefers the Build America Bond structure because it is viewed as a more efficient way to offer tax subsidies to state and local governments. By making municipal bonds taxable, you open up the pool of investors to a much larger and diverse group. Taxable mutual funds, pension funds, and foreign investors are all potential buyers. This should increase liquidity and reduce interest rates for municipal issuers. Also, by issuing cash subsidies, the federal government has more flexibility to adjust the amounts of the subsidy to incentivize different types of projects. Build America Bonds may just be the start of a larger push to drastically reduce the issuance of traditional tax-free municipal bonds.

Timothy Strauts is an ETF analyst with Morningstar.

Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including Barclays Global Investors (BGI), Claymore Securities, First Trust, and ELEMENTS, for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.

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