Overview: This commentary discusses Build America Bonds, which have garnered headline attention lately. The creation of Build America Bonds (BABs) aims to ease access to capital for strapped state and local governments. It is important to note that the market for this debt is rapidly evolving and constantly shifting.

 

In April, new issuance of taxable bonds hit its highest level since June 2003, thanks to some of the market’s largest issuers selling billions of dollars of Build America Bonds (BABs). BABs were created as part of the stimulus package in the American Recovery and Reinvestment Act of 2009. The introduction of BABs creates a taxable issuance option for some municipal issuers that would have traditionally issued in the tax-exempt market. By issuing BABs, municipal markets either receive a 35 percent rebate on interest costs or provide tax credits to investors that are subsidized by the federal government. The 35 percent subsidy allows BAB issuers to effectively obtain lower borrowing rates and offer more attractive yields to investors.

 

After only a couple of weeks of BAB issuance, sales of BABs have reached nearly $10 billion and are climbing. Some estimate that sales may reach $50 billion annually over the next two years. Others suggest the market may grow to as much as $150 billion.

 

The increased issuance brings more attention to the taxable municipal sector. When compared with corporate bonds, BABs offer an attractive alternative. For example, current 10-year BABs offer yield pickups over 10-year corporate bonds ranging from 44 basis points for A rated to 121 basis points for AAA rated. Yet 15-year cumulative default rates for municipals have been much lower than those for corporate bonds. Bloomberg noted on May 4, 2009 that investors were snapping up BABs because they offered comparable yields to companies with lower ratings. In addition, most BABs contain “make whole provisions,” which protect investors from borrowers paying off the bonds early if rates fall.

 

The taxable issuance is also taking pressure off of the tax-exempt market by reducing supply. Tax-exempt municipal bonds have rallied since the first BABs came to market, pushing yields on 30-year AAA tax-exempt securities down as much as 19 basis points to a seven-month low of 5 percent.

 

Issuance is focused primarily in maturities greater than 12 years (which is longer than we typically recommend), and shorter-term BABs are much harder to locate. In addition, the spread advantage of taxable municipal BABs is expected to narrow as investors and issuers adjust to the dynamics of this new market. In the meantime, the smaller issues (when they can be found) may provide opportunity for investors to pick up incremental yield.