Tuesday, May 25, 2010

Build America Bonds

Just in case the Series 7 throws a question at you about "Build America Bonds," let's say a few words about them here. BABs are issued by states and cities, but, unlike typical municipal bonds, these are taxable to the investor. The issuer has to, therefore, pay a higher nominal yield to investors, but the issuer receives a big chunk of the interest they pay right back from the US Government. The Build America Bonds are designed to stimulate the rebuilding of infrastructure (roads, bridges, sewers, etc.), and are authorized under the American Recovery and Reinvestment Act of 2009. Basically, the federal government is helping municipalities to rebuild infrastructure by allowing them to sell bonds to a bigger group of investors compared to those who typically buy the tax-exempt municipal bonds. See, since the interest payment the investor receives is taxable, any bond investor might be interested, not just high-bracket investors who typically buy tax-exempt municipal bonds. As the US Treasury explains, low-income investors, corporate bond investors, and pension funds--who would normally not buy municipal bonds--will in many cases be interested in buying the taxable municipal bonds called "BABs." How does the issuer benefit by paying a higher interest rate? The federal government reimburses the issuer for 35% of the interest paid to investors. As the US Treasury explains, if an issuer sells a 10% bond to an investor, the issuer receives 35% of that back from Uncle Sam, making their net borrowing cost just 6.5%, while being able to sell bonds to a wider spectrum of investors. The way I just described BABs actually applies to just one type of them, which we could call the "BABs - Direct Payment." There is another type in which the tax credit is given to the investor, and we could call these "BABs - Tax Credit." The investor's tax credit is also equal to 35% of the interest payable on the bonds. The effective savings that the bond issuer realizes is not as high on the "tax credit" BABs, but these bonds also don't carry as many restrictions. Basically, as long as the "tax credit" bonds would normally pay tax-exempt interest and are issued before January 1, 2011, they can be used for virtually any purpose. On the other hand, with "direct payment" BABs issuers have to use virtually all the money raised to build something (capital expenditures), while the money raised through "tax credit" BABs can be used for both capital expenditures (building stuff) or working capital (paying bills). They can also be used to perform refundings and no more than one advance refunding.
If the test brings these Build America Bonds up at all, I would anticipate that it would focus on the main points:
  • they pay taxable interest to the investor
  • the issuer receives a direct payment (refundable credit) from the US Treasury of 35% of the interest paid on the bonds for "direct payment" BABs
  • the investor receives a tax credit of 35% of the interest received from the issuer for "tax credit" BABs
  • BABs are not guaranteed by the federal government/not direct obligations

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