Build America Bonds
By Stephen Smith
Build America Bonds were established as part of the economic stimulus plan known as the American Recovery and Reinvestment Act of 2009 which was signed into law by President Obama on February 17, 2009. Build America Bonds allow state and local governments to issue taxable bonds that provide federal subsidies to offset a portion of their borrowing costs. The subsidies can take the form of either tax credits for investors or preferably a refundable tax credit paid directly to the state and local government issuers of the bonds.
The purpose of the initiative is to help rebuild the country’s infrastructure while providing cost savings to issuers of state and local government debt. Many municipalities seeking access to the capital markets are facing higher financing costs created by the economic downturn and financial crisis. Issuing debt at a taxable rate with a federal subsidy should result in a lower net interest cost for an issuer than is possible in the tax-exempt market. This is the first time municipal issuers have been able to issue debt in the taxable market and receive cash subsidies from the federal government. This provision is set to expire at the end of 2010.
When Build America Bonds are initially offered, the issuer can opt for either an investor subsidy or an issuer subsidy. The investor subsidy provides a federal tax credit to investors in an amount equal to 35% of the coupon interest rate over the life of the bonds. The issuer subsidy provides for a refundable tax credit paid directly to state and local government issuers by the Treasury Department and the Internal Revenue Service in an amount equal to 35% of the coupon interest rate over the life of the issue. Given the higher effective subsidy this direct tax credit provides, we expect the vast majority of Build America Bonds to be issued this way.
The launch of taxable Build America Bonds in the Muni market is likely to shift some supply from the traditional tax-exempt market to the taxable market. The volume in 2010 could reach $150 billion in issuance. Build America Bonds generally will be issued with the same security features as the issuer’s tax-exempt securities. For example, if a municipality has announced plans to issue tax-exempt and taxable general obligation bonds as part of the same issue, the underlying rating will be exactly the same. Build America Bonds provide another arrow in the quiver of prudent fixed income investments available to us and may be appropriate in many of our clients’ portfolios as a way to enhance returns in a conservative manner.