Build America Bonds: Should They Be Part of Your Portfolio?

You may have heard about a new investing opportunity called Build America Bonds. Created as part of President Obama’s stimulus package passed in early 2009, the new investments are providing cash-strapped municipalities with access to capital so they can build roads, improve facilities and take on other projects. They are also providing some investors with a higher-yielding alternative to many corporate and traditional muni bonds. But Build America Bonds come with tax implications and they can be challenging for individual investors to purchase.

MADE FOR INSTITUTIONAL INVESTORS BUT INDIVIDUALS MIGHT WANT TO GET IN ON THE ACTION

You’ve probably seen the road signs proclaiming that the construction projects you were driving past were financed in part by the federal American Recovery and Reinvestment Act.

State and local governments also contribute funding to those projects and a new type of bond that they issue to raise money for them was designed for institutional investors. But they may be a good deal for individual investors, too. Reason: These Build America Bonds offer yields similar or slightly higher than corporate bonds, but they are relatively safe so they don’t pose the short-term default risk that some lower-rated corporates do.

Build America Bonds, or BABs, are similar to municipal bonds but there is one important difference. The income they generate is taxable for federal tax purposes.

There are two types of BABs. Here’s how they work:

With the first type, the federal government gives BAB issuers a subsidy equal to 35 percent of the interest they pay investors for buying the bonds. The subsidy is what allows issuers to offer interest rates competitive with those of less-than-investment-grade corporate bonds. For example, California issued a slew of BABs with a very attractive 7.4 percent interest rate. With the federal subsidy, the state only has to pay 4.8 percent of that interest. It can keep the rest.

With the second type, the federal government gives BAB holders a tax credit equal to 35 percent of the annual interest they earn on the bonds. If a bondholder’s tax liability is too low to qualify for the credit, he or she can carry it over to the next tax year.

Build America Bonds are extremely popular among state and local governments, because the federal subsidies lower their borrowing costs and because they have helped revive investors’ interest in the previously moribund municipal bond market. That, in turn, may save taxpayers money on their state and local taxes.

Moreover, the bonds have saved or even created jobs and have helped stimulate the economy.

BABs have proven popular among pension plans and other institutional investors, too. The first ones were issued in April 2009 and so far, more than $50 billion worth have been issued. They have an average yield of just under six percent. The New Jersey Turnpike Authority originally planned to issue $250 million in BABs, but ended up issuing $1.32 billion.

In fact, they are so popular that none are available to individual (or retail) investors in the primary market. But individuals can still get in on the action, in a few ways:

They can invest in bond funds that contain Build America Bonds.

They can buy BABs in the secondary market, in other words, from other investors. They are likely to cost more, but purchasers could still come out ahead.

They can be on the look-out for smaller issues that won’t be gobbled up by institutions as fast as the big California and New Jersey offerings were.

The Build America Bond Program is scheduled to terminate at the end of 2010, but the Obama administration has expressed interest in extending it into 2011 or beyond and expanding it by letting states sell BABs to refinance their debt on tax-exempt bonds.

One downside for investors is liquidity. BABs tend to have extended maturities – 30 years in some cases. That’s fine for an investor who has a long time horizon and is looking for a steady source of income. But the bonds’ issuers have to remain solvent in order to make interest payments to bondholders, and the federal government has to remain solvent to continue subsidizing the bonds. That may not be a short-term worry, but given the relentless growth in spending on entitlement programs and service on the national debt, the government’s long-term fiscal solvency can’t be taken for granted.

Bottom line: BABs are complex and were built for institutional investors, so they may not be suitable for many individuals. The decision depends on many factors, including your tax bracket. Your financial and tax advisers can help determine whether the bonds meet your investment goals and should have a place in your portfolio.

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TAXABILITY

Interest from municipal bonds is exempt from federal taxes. Plus, if you live in the state where a bond is issued, the interest is exempt for state tax purposes.(Even if interest is tax exempt, when an investor redeems or sells a muni bond, any capital gain is taxable.)

In contrast, interest income from Build America Bonds is taxable for federal tax purposes. But investors may be able to claim a tax credit to offset part of it. (And there are state tax breaks if the purchaser resides in the state where the bond is issued.)

As with all investments, compare the after-tax yield to help determine if bonds are a suitable choice for you.

BUSINESS WISDOM FOR TODAY’S ECONOMY

Looking for year-end tax savings? If you prepay next year’s state and local taxes before January 1, you may increase your deduction for 2009. But don’t prepay if you expect to owe the alternative minimum tax (AMT) this year because state and local taxes are not deductible for AMT purposes.