Munis' Worthy Rivals

Income Investing

Munis' Worthy Rivals

Build America Bonds sound like winners -- except for taxpayers, who get stuck footing the bill.

Build America Bonds help cities, counties and states patch roads, fix sewers and upgrade dilapidated schools. In the ten months since this new class of taxable bonds first appeared, municipalities have sold $58 billion worth, and many more are coming. Chris Mier, managing director of Loop Capital, a Chicago bond brokerage and research firm, estimates that municipalities will float about $150 billion of BABs in 2010. That would represent 35% of all expected municipal-bond issurance this year. Taxable munis barely existed before BABs.

The emergence of BABs marks a profound change in the once-placid municipal-bond market. That market is rapidly morphing from a place known for low-risk, low-yielding, tax-free investments into a two-tier market in which new tax-free bonds tend to carry shorter maturities and taxable munis tend to carry longer maturities -- and to trade at yields that are sometimes comparable to those of corporate bonds.

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For example, in mid January, the state of Pennsylvania issued a whopping $600 million of BABs with rates as high as 4.65% for 16 years and 5.45% for 20 years. On the very same day, Pennsylvania issued $300 million of tax-free securities -- for terms of one to nine years at yields from 2.0% to 4.3%.

In light of these changes, you may need to rethink your approach to municipal bonds. If you’ve avoided munis because you don’t need a low-yielding, tax-free investment, you might find the Build America Bonds useful. They fit well inside a tax-deferred account, such as an individual retirement account.


But what if you’re retired, prefer tax-free income and spend the interest as soon as it arrives? Then you’re probably unhappy. Bond brokers and fund managers say it’s tough -- and getting tougher -- to find new, high-quality, long-term tax-exempts with generous yields. That’s what I mean when I say the muni market is changing rapidly. If Congress extends the BAB program beyond its scheduled close at the end of 2010 -- and the lobbying to extend it is fierce -- the traditional tax-free market will shrink, and BABs will likely become the dominant factor in the muni-bond market in the future.

Complicating factor. All this began as part of the government’s massive stimulus program. The centerpiece of BABs is a federal interest subsidy that works in one of two ways. In one variety, the bondholder gets a federal tax credit of 35% of the interest income every year for the life of the bond, regardless of tax bracket. In the second, which is quickly becoming the more common type, the Treasury directly pays 35% of the bond issuer’s interest cost.

That means that when Pennsylvania sells those 20-year BAB bonds at 5.45%, the Treasury (meaning taxpayers from all over the nation) picks up enough of the interest tab so that Pennsylvania actually pays a net of 3.5%. But you, the investor, get 5.45%, a yield that is in the ballpark of current interest payments on single-A-rated corporate bonds maturing in 15 to 20 years from companies such as Archer Daniels Midland, Deere and Halliburton.

No wonder most mayors, county executives and governors love the BAB program and want to extend it. If they issue 30-year BAB bonds today, their jurisdictions will continue to get the subsidy from Uncle Sam until 2040, although the interest subsidy will probably be reduced to 25% to 30% if the program is reauthorized.


The feds, and this is important, do not insure or guarantee any BAB principal or interest payments. State and local governments and their entities still have to make good on their obligations. BABs carry ratings from triple-A to just above junk. Some of the bonds are backed by taxes and others by revenues from tolls, water bills or whatever.

Once you cut through the politics and the financial gobbledygook, you can almost imagine BABs to be a new kind of corporate bond -- except that the “companies” that issues the bonds run states, cities, toll bridges and school systems, and are owned by taxpayers rather than by stockholders.

You can find BABs listed for sale at places such as the Schwab and Fidelity online bond markets. If you plug “Build America Bonds” into your favorite search engine, you should find a schedule of new issues in registration. BAB mutual funds are also appearing. One is Eaton Vance Build America Bonds Fund, a load fund with multiple share classes (EBABX is the most common version). PowerShares Build America Bond Portfolio (BAB) is an exchange-traded fund that buys these bonds. Both are too new to judge, but I’d caution investors that BABs funds may be more volatile than the typical muni-bond fund because of their wider ownership base.