Build America Bonds (BABs): Types, Restrictions, Vs. Other Bonds

BABs are taxable municipal bonds issued by state and local governments to finance capital projects such as roads, bridges, schools, and other infrastructure. Unlike traditional municipal bonds, which are typically tax-exempt, BABs offer a federal subsidy to issuers or a tax credit to investors, making them attractive despite their taxable status. The program was active from April 2009 to December 2010, but its impact continues to influence public finance discussions.

The BABs program was a response to the credit market freeze during the 2008 recession, which made it difficult for municipalities to issue bonds at affordable rates. By offering federal subsidies, BABs reduced borrowing costs and encouraged infrastructure investment, creating jobs and supporting economic recovery.

Types of Build America Bonds

BABs were offered in two primary types, each with distinct features tailored to different issuer and investor needs:

1. Direct Payment BABs

Direct Payment BABs provided issuers with a federal subsidy equal to 35% of the interest paid to bondholders. This subsidy effectively lowered the net borrowing cost for state and local governments. For example, if a municipality issued a BAB with a 6% interest rate, the federal government would reimburse 35% of that interest (2.1%), reducing the issuer’s effective interest cost to 3.9%.

• Key Features:
  • The subsidy was paid directly to the issuer, typically on a semiannual basis.
  • Issuers could use the bonds for any capital project eligible under traditional municipal bond rules, such as public buildings, transportation infrastructure, or utilities.
  • Direct Payment BABs were the most common type, accounting for the majority of BAB issuances.
• Advantages:
  • Lowered borrowing costs compared to traditional taxable bonds.
  • Enabled municipalities to fund projects during a period of tight credit markets.
  • Attracted institutional investors, such as pension funds and foreign investors, who typically avoided tax-exempt bonds.
• Challenges:
  • The subsidy was subject to federal budget constraints, including sequestration cuts starting in 2013, which reduced payments to issuers and created uncertainty.
  • Issuers remained responsible for the full interest payment if federal subsidies were delayed or reduced.

2. Tax Credit BABs

Tax Credit BABs offered bondholders a federal tax credit equal to 35% of the interest earned, which could be applied against their federal income tax liability. Unlike Direct Payment BABs, the federal government did not subsidize the issuer directly; instead, the tax credit enhanced the bond’s yield for investors.

• Key Features:
  • The tax credit was non-refundable, meaning it could only offset taxes owed and was less valuable to investors with low or no tax liability.
  • Tax Credit BABs were less common than Direct Payment BABs due to their complexity and limited appeal to certain investors.
  • Like Direct Payment BABs, they could finance a wide range of capital projects.
• Advantages:
  • Increased after-tax returns for investors, making the bonds competitive with other taxable securities.
  • Expanded the investor pool to include taxable accounts, such as mutual funds and insurance companies.
  • Provided issuers with access to capital without relying on direct federal payments.
• Challenges:
  • The tax credit’s value depended on the investor’s tax situation, reducing its appeal for tax-exempt entities or low-tax-bracket investors.
  • Complexity in calculating and applying the tax credit deterred some investors.
  • Limited issuance compared to Direct Payment BABs, as issuers preferred the certainty of direct subsidies.

Restrictions on Build America Bonds

While BABs offered flexibility for infrastructure financing, they came with specific restrictions to ensure compliance with federal guidelines and prevent abuse:

1. Eligible Projects:
   • BABs could only finance capital expenditures, such as construction or improvement of public infrastructure. Operating expenses, like salaries or maintenance, were ineligible.
   • Projects had to comply with existing municipal bond regulations, including public purpose requirements.
2. Taxable Status:
   • Unlike traditional municipal bonds, BABs were fully taxable at the federal level, requiring issuers to compete with other taxable securities, such as corporate bonds.
   • This taxable status necessitated higher interest rates to attract investors, though federal subsidies or tax credits offset some of the cost.
3. Program Deadline:
   • The BABs program was temporary, with issuances allowed only between April 2009 and December 2010. No new BABs could be issued after this period, though outstanding bonds continued to receive subsidies or tax credits.
   • The expiration limited the program’s long-term impact, though discussions about reviving BABs have persisted.
4. Federal Subsidy Risks:
   • Direct Payment BABs relied on federal subsidies, which were vulnerable to budget cuts. Sequestration in 2013 reduced subsidy payments by approximately 8.7%, increasing issuer costs and highlighting the program’s dependence on federal funding.
   • Issuers had to account for the possibility of subsidy reductions when budgeting for debt service.
5. Private Activity Restrictions:
   • BABs were subject to the same private activity bond rules as traditional municipal bonds. No more than 10% of the bond proceeds could be used for private business purposes, and no more than 10% of debt service could be secured by private payments.
   • These restrictions ensured BABs primarily served public infrastructure needs.
6. Reporting Requirements:
   • Issuers of Direct Payment BABs were required to file reports with the IRS to receive subsidies, adding administrative complexity.
   • Non-compliance could result in delayed or withheld subsidy payments.

Build America Bonds vs. Other Bonds

To understand BABs’ role in public finance, it’s useful to compare them with other bond types, including traditional municipal bonds, corporate bonds, and Treasury securities. Each has distinct features that influence issuer and investor decisions.

1. BABs vs. Traditional Municipal Bonds

• Tax Status:
  • Traditional municipal bonds are typically tax-exempt at the federal level and often at the state level for in-state investors. BABs are taxable, requiring higher interest rates to compete in the market.
  • The federal subsidy (Direct Payment BABs) or tax credit (Tax Credit BABs) offsets the taxable disadvantage, making BABs’ net cost to issuers comparable to or lower than tax-exempt bonds during the program’s active period.
• Investor Base:
  • Tax-exempt municipal bonds primarily attract high-income individuals and entities seeking tax-advantaged income. BABs appealed to a broader audience, including pension funds, foreign investors, and taxable accounts, due to their competitive yields and federal backing.
  • BABs’ taxable status allowed issuers to tap into global capital markets, which was critical during the 2008–2009 credit crunch.
• Cost to Issuers:
  • Traditional municipal bonds generally have lower interest rates due to their tax-exempt status, but BABs’ federal subsidies often made them cheaper to issue during tight market conditions.
  • For example, a 2010 study by the U.S. Treasury estimated that BABs saved issuers approximately 112 basis points (1.12%) compared to tax-exempt bonds, thanks to the 35% subsidy.
• Use of Proceeds:
  • Both BABs and traditional municipal bonds are restricted to capital projects, but BABs’ taxable status allowed greater flexibility in structuring deals to attract diverse investors.

2. BABs vs. Corporate Bonds

• Credit Risk:
  • BABs are backed by state or local governments, often with strong credit ratings or dedicated revenue streams (e.g., general obligation or revenue bonds). Corporate bonds carry varying levels of credit risk depending on the issuer’s financial health.
  • BABs benefited from federal subsidies, reducing issuer risk compared to corporate bonds, which rely solely on the issuer’s ability to pay.
• Yield and Taxation:
  • Both BABs and corporate bonds are taxable, but BABs offered federal subsidies or tax credits, enhancing their effective yield for issuers or investors. Corporate bonds typically have higher yields to compensate for credit risk but lack federal support.
  • BABs’ yields were competitive with high-grade corporate bonds, making them attractive to institutional investors during the program’s tenure.
• Purpose:
  • BABs finance public infrastructure, while corporate bonds fund private-sector activities, such as business expansion or acquisitions. This distinction makes BABs a tool for public welfare, while corporate bonds serve corporate profitability.

3. BABs vs. U.S. Treasury Securities

• Safety:
  • U.S. Treasuries are considered risk-free, backed by the full faith and credit of the federal government. BABs carry slightly higher risk due to their municipal backing, though many were highly rated.
  • Investors seeking safety preferred Treasuries, while those willing to accept minimal risk for higher yields (with federal subsidies) found BABs appealing.
• Yield:
  • BABs offered higher yields than Treasuries due to their taxable status and municipal credit risk, but the federal subsidy or tax credit narrowed the gap for issuers and investors.
  • During 2009–2010, BABs’ yields were often comparable to Treasuries after accounting for subsidies, making them a viable alternative for infrastructure-focused investors.
• Purpose:
  • Treasuries finance federal government operations and debt, while BABs fund state and local infrastructure. BABs’ proceeds directly supported economic recovery through job-creating projects, unlike the broader fiscal role of Treasuries.

Impact and Legacy of Build America Bonds

During their brief existence, BABs had a significant impact on public finance:

• Volume and Scale:
  • From April 2009 to December 2010, over $181 billion in BABs were issued across more than 2,200 deals, according to the U.S. Treasury. This represented about 20% of total municipal bond issuance during the period.
  • BABs financed critical infrastructure, including highways, transit systems, schools, and water facilities, supporting economic recovery.
• Cost Savings:
  • The Treasury estimated that BABs saved issuers billions in interest costs compared to traditional taxable bonds, thanks to federal subsidies and access to a broader investor base.
  • For example, California issued over $20 billion in BABs, leveraging subsidies to fund projects at lower net costs than market-rate taxable bonds.
• Market Innovation:
  • BABs expanded the municipal bond market by attracting non-traditional investors, such as pension funds and international buyers, who typically avoided tax-exempt securities.
  • The program demonstrated the potential for taxable municipal bonds to compete in global capital markets, paving the way for future innovations.
• Challenges and Criticism:
  • The program’s reliance on federal subsidies created uncertainty, particularly after sequestration cuts reduced Direct Payment BABs’ subsidies starting in 2013.
  • Critics argued that BABs increased federal spending and shifted infrastructure funding responsibility from local to federal governments.
  • The 2010 expiration disappointed issuers, who valued BABs’ flexibility and cost savings.

Potential Revival of BABs

Since the program’s end, policymakers and analysts have periodically proposed reviving BABs to address ongoing infrastructure needs. Proponents argue that a modernized BABs program could:

• Support President Biden’s infrastructure initiatives, such as the Bipartisan Infrastructure Law of 2021, by providing cost-effective financing.
• Attract private capital to public projects, reducing reliance on federal grants.
• Offer a stable funding mechanism for states and localities facing budget constraints.

However, opponents highlight concerns about federal budget impacts and the complexity of administering subsidies. Any revival would likely need to address sequestration risks and streamline reporting requirements to ensure issuer confidence.

Conclusion

Build America Bonds were a bold experiment in public finance, blending taxable municipal bonds with federal subsidies to fund infrastructure during a critical economic period. Their two types—Direct Payment and Tax Credit BABs—offered issuers and investors flexibility, while restrictions ensured alignment with public purposes. Compared to traditional municipal bonds, corporate bonds, and Treasuries, BABs carved a unique niche by balancing cost savings, broad investor appeal, and infrastructure investment.