Four Attractive, Unique CEFs for Income Potential

The last few months have presented investors with many obstacles. The European sovereign debt crisis, coupled with worsening macroeconomic figures, paints a bleak outlook for future investment returns. Some investors have responded by "fleeing" to the perceived safety of U.S. Treasuries despite the recent downgrade. But Treasuries have seen yields continually pushed to new lows, as have municipal bonds now that widespread, media-fueled panic over massive defaults seems to have abated. Municipal-bond yields have been pushed so low, in fact, that many districts are taking advantage of this by refinancing debt.

Income-hungry investors are in a seemingly tough spot--forced to choose between depressingly low yields and taking on higher risk in search of yields. But these are not the only options. A unique subcategory of municipal closed-end funds, or CEFs, invests in Build America Bonds, or BAB, and includes just four funds. Because these funds tend to employ less leverage and hold portfolios with higher-credit quality compared to their tax-free municipal counterparts, they offer investors a viable, attractive option to get out of the tight spot they are in.

What Are Build America Bonds?
Let’s take a step back first. Build America Bonds were created under the American Recovery and Reinvestment Act of 2009. Unlike traditional municipal-bond income (interest payments to bondholders), the income from BABs is not exempt from federal or state taxes. Instead, the U.S. Treasury subsidizes 35% of the bond’s coupon payments, allowing municipalities to pay higher interest payments to attract investors. The initial program, which ended at the close of 2010, created a $181 billion market for these bonds. As it became apparent that the program would not continue, many municipalities rushed to take advantage of the federal subsidies, and almost one quarter of the outstanding notional value of this bond category was issued in the final three months of 2010.

But while these may look and smell like traditional tax-free municipal bonds, BABs comprise a separate asset class with their own set of risks. Because the program was not renewed after 2010, the BAB market’s future remains unclear. There is currently no new supply of these bonds. The Obama administration's fiscal 2012 budget outlines the expansion of the program with a reduced 28% subsidy, but it faces political opposition. If the program is not resurrected, the market could become even more illiquid, making it difficult for funds to maintain a BAB-oriented strategy. On top of this, these bonds face a slew of other risks related to the subsidy, ranging from its possible elimination by Congress to an unfavorable IRS audit. (The IRS can disallow some of the subsidy if it determines that the price of the bonds, when initially sold to investors, was based on an incorrect audit). In light of this uncertainty, higher yields may be justified.

Build America Bond CEFs 
The table below lists the four Build America Bond CEFs in existence.

The funds’ performance over the last three volatile months indicates their status as "risk-off" investments; until last week, the three-month net asset value, or NAV, total returns were the highest in the CEF universe. The two funds with the longest histories--Nuveen Build America Bond NBB and BlackRock Build America Bond BBN--were among the top 10 performers of all CEFs over the short time frame. But as public perception began to shift toward increased stability in the eurozone (risk back on), performance has waned. These funds were four of the worst five CEF performers of the last week. BBN fell 4.5%, NBD fell 4.2%, NBB fell 3.6%, and GBAB fell 2.8%.

After adjusting for a 35% tax rate (as tax-free municipal income distribution rates are pretax rates), these funds' distribution rates are notably lower than their tax-exempt municipal-bond peers. Part of this is likely due to the fact that they tend to hold higher-quality portfolios. (Three of the funds are tied for the highest-weighted average credit scores in the muni CEF universe.) Furthermore, these funds have lower leverage ratios than the average of the broad municipal CEF group (1.36 versus 1.55, respectively). Largely reflecting the illiquid nature of the underlying securities, the uniqueness of the category, and the lower-than-average tax-adjusted distribution rates, all of these funds are currently trading at decent discounts, which boosts their distribution rates at the share price (yield enhancement at work).

BlackRock Build America Bond BBN 
With net assets of close to $1.3 billion, this is the largest fund in the bunch and also the best performing. This fund is barely a year old, but it has had a great year: The fund’s NAV total return has been 22%. A weighted-average credit rating of AA- and a leverage ratio of 1.44, which is average for municipal CEFs, make its performance all the more impressive. The fund's leverage is made up mostly of reverse repurchase agreements, with small exposure to tender-option bonds. The fund also uses futures contracts to hedge interest-rate risk.