We take a look at Build America Bond closed-end funds.
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.
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.
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).
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.
The fund also had the lowest adjusted expense ratio of the group at 0.81% in the latest fiscal year. (Note that, because the fund's annual report is for a period less than a full fiscal year, the expense ratio is annualized.) The fund is managed by a four-person team led by Theodore Jaeckel. Jaeckel has 15 years of asset-management experience and manages over $19 billion in municipal assets across various funds and accounts. Three of the four portfolio managers own shares of the fund, which we like to see.
The fund's distribution had been stable since its inception and was just increased by 10% to $0.1298 a share this month. The distribution has been paid almost entirely out of income (with the exception of a small amount of short-term capital gains in December of 2010) and has yet to be decreased. An important caveat is that if no BABs or other taxable municipal bonds with federal subsidies are issued by the end of 2016, the board of directors will consider changing the fund's investment policy or terminating the fund.
Build America Bond Term NBB
Nuveen Build American Bond Opportunity NBD
NBB was the first BAB closed-end fund launched in April 2010 and was followed by NBD in November of the same year. These two funds are run by the same team. Daniel Close manages 16 municipal CEFs, while John Miller manages three along with two mortgage-based CEFs. Neither manager owns stake in either fund.
The funds' latest fiscal year expense ratios were low on an absolute basis: NBB at 0.86% and NBD at 0.84%. Because neither fund had completed a full fiscal year at the time of the latest annual report, their expense ratios are annualized.
Though the funds' strategies are identical--to seek income from taxable municipal bonds that can claim federal subsidies--their portfolio holdings differ slightly. The different portfolio constructions and total leverage ratios have led to different performance. Year to date, NBB’s NAV total return has been 16%, while NBD has gained nearly 20%. NBB and NBD have kept consistent, income-only distributions since their inceptions, paying $0.117 and $0.126 per share, respectively.
For leverage, NBB relies primarily on tender-option bonds and also uses bank loans, while NBD relies only on tender-option bonds. Both funds use swap contracts to hedge their exposure to interest-rate risk. These funds also have highly rated portfolio holdings, both with weighted-average credit ratings of AA-. If BABs are not renewed, or if a similar security is not issued, by the end of 2016, the funds have a windup provision to liquidate in 2020.
Build America Bonds Managed Duration GBAB
This fund is slightly different from the other three funds. Though it has large holdings in BABs, it also invests in corporate bonds (6.5% of holdings) and asset-backed securities (6% of holdings). The portfolio's average-weighted credit quality of BBB is the lowest in the group, which is on par with the broader municipal category. However, the fund's non-BAB holdings make the fund riskier than this metric would normally indicate because these securities are rated on a different basis than munis. BBB corporate bonds, for example, tend to have much higher default rates than BBB muni bonds. This skews the metric because it is not an apples-to-apples comparison.
This fund's performance gives a different perspective of the BAB market in relation to investors' risk preferences over the last few months. The fund's total-return NAV performance is right in the middle of the pack, returning 19.6% year to date. Considering the fund's low-credit quality, it is surprising that its distribution rate is the lowest of the group at 6.5% of NAV or $0.117. Like the other funds, GBAB's distribution has been stable and comprised entirely of income since inception. For leverage, GBAB uses reverse repurchase agreements and does not use any derivatives to hedge interest rates.
Scott Minerd, Anne Walsh, and James Pass have managed this fund since inception. Walsh and Pass own between $10,000 and $15,000 worth of shares, but Minerd owns none. The fund's expense ratio of 0.91% (annualized, like the others) makes it the most expensive of the BAB funds, but still cheaper than the average municipal CEF (1.10%). Though GBAB has no set timeline for its demise or evolution, it has a similar windup provision as the other three funds: If the BAB program is not resurrected, or if a similar program is not adopted, the board of directors will consider a number of options for the fund, including potential mergers, broadening the investment policy, and liquidation.
These four funds offer investors attractive distributions with relatively low default risk. But their future performance is largely dependent on the future of BABs themselves. Income-seeking investors who are either optimistic about BABs' resurrection or are unconcerned about the potential changes in these funds' investment objective may wish to take a fresh look at these securities, given their appealing characteristics and currently decent discounts.