Possibly the most notable development in the muni market in 2009 has been the emergence of Build America Bonds. This topic has been discussed previously in this space, but with their increasing impact on the overall muni market, they are commanding more and more investor attention.
BABs, enacted through the American Recovery and Reinvestment act, are taxable alternatives to traditional tax-exempt state and local government debt. Under the federal program, instead of selling tax-exempt bonds, municipalities can sell taxable bonds and receive a cash subsidy from the Treasury equal to 35% of the interest cost. BABs are familiar to traditional buyers of tax exempt bonds, since both the names of the issuers and the nature of the bond security are the much the same as traditional tax-free munis.
In a recent Bond Buyer article (“BAB’s Help Pump Up Volume” September 1, 2009) they noted that from the standpoint of municipal supply, BABs constituted 31% of total supply in the month of August, up from their peak of 30% in April. For issuers, the greatest savings gained from using BABs is in 15-year and longer maturities. As a result, the supply of longer maturity tax-free bonds has diminished considerably, bringing yields on the long-end down.
Over time, BABs are becoming more readily accepted by individual investors, particularly for IRA accounts. This is not surprising, considering the fact that BABs provide a considerably better risk/reward dynamic than corporates. As BABs inevitably gain wider acceptance, the extreme values we are seeing today will diminish to a degree. In the meantime, taxable fixed income investors will continue to reap the rewards of this growing market.