BABs, or Build America Bonds, are a special subset of municipal bonds created as part of the 2009 American Recovery and Reinvestment Act. They are designed to facilitate state and local government money raising via special tax credits and subsidies for issuer and bondholder.
Q. So these are very unusual sorts of municipal bonds, right?
A. Right, “Babs” stands for “Build American Bonds,” and the key provisions for them were included in the 2009 stimulus act. They’re meant to help state and local government raise capital effectively, and they’ve been used to finance various infrastructure projects, but they aren’t like normal municipal bonds, because the interest they pay is taxable, instead of tax exempt.
Q. So how do they work exactly?
A. There are two kinds of Babs. In one, the Federal government subsidizes the interest rate payable by the municipality so that it can afford to issue at rates comparable to normal corporates. One of the big original issuances, for example was a $5 billion offering by California, which went out at 7.4% — but the state paid only 4.8% of that.
Q. What’s the point? Why not just issue traditional tax exempt municipal bonds?
A. The idea is that the Babs structure, does costs the Federal government something, but not as much– at least according to some folks — as providing the tax exemption for the entire amount payable. One reason for that is that broadening the base of possible buyers: now you can sell to pension plans, for example, which have no interest in traditional tax exempts. And also to other buyers just looking for higher yield.
Q. You said there were two kinds?
A. In the other, the government provides a tax credit equal to 35% of the interest received directly to the holder. So in one case the federal subsidy goes to the local issuer; in the other case, to the bond holder.
Q. And are they popular?
A. With holders, yes: the municipalities are pretty good credits and the total Bab yield is pretty good. In fact, they’re a little hard to find right now – they’re aren’t any new issuances at the moment – but there is trading in the secondary market, and for smaller investors some mutual funds specialize in these things.