What are Build America Bonds (BABs)?
– Build America Bonds were a special type of municipal (local government) bond created by the American Recovery and Reinvestment Act (ARRA) of 2009. Unlike most munis, BABs were taxable at the federal level but carried a federal subsidy equal to 35% of interest payments. The program was intended to lower borrowing costs for state and local governments during the post‑2008 recession. The program expired for new issues after 2010 (new capital‑expenditure BABs had to be issued before Jan. 1, 2011).
Key definitions
– Municipal bond (muni): A debt security issued by a state, city, county or other local government to finance public projects.
– Taxable municipal bond: A muni whose interest income is subject to federal income tax.
– Refundable tax credit: A tax credit that can reduce tax owed to below zero, creating a refund.
– Direct payment subsidy: A cash payment from the federal government to the issuer equal to a percentage of interest paid.
Why BABs were created (brief)
– After the 2008 financial crisis many investors avoided non‑federal debt and state/local governments faced higher borrowing costs. BABs combined federal support with market access to help finance infrastructure and capital projects while appealing to taxable bond investors.
Two main types of BABs
1. Tax‑credit BABs
– The federal government provided a taxable‑bond investor with a refundable tax credit equal to 35% of the bond’s interest in each year.
– The credit lowered the investor’s net tax bill; unused credit could be carried forward or refunded depending on IRS rules.
2. Direct‑payment BABs
– The federal government paid the issuer 35% of the interest the issuer owed to investors.
– That subsidy reduced the issuer’s effective borrowing cost, allowing the issuer to offer more attractive coupons
– How the two BAB types affected pricing (summary)
– Tax-credit BABs (investor receives a federal tax credit equal to 35% of interest): The investor’s after‑tax cash flow = coupon × (1 − investor tax rate + 0.35). Because the 35% credit was refundable (or could in some cases be carried forward), the credit could more than offset the investor’s tax on interest, making tax‑credit BABs attractive to taxable investors with limited use for tax‑exempt munis.
– Direct‑payment BABs (issuer receives a federal payment equal to 35% of interest): The investor receives taxable interest only; the issuer’s effective borrowing cost = coupon × (1 − 0.35) = coupon × 0.65. That allowed issuers to offer lower coupons than they would have on a taxable bond without subsidy and still achieve a low effective cost.
Worked numeric examples — two simple comparisons (per $1 face)
1) Direct‑payment BAB, coupon = 5.00% annual, investor marginal federal tax rate = 32%
– Investor pre‑tax interest = $0.05 per $1.
– Investor after‑tax interest = 0.05 × (1 − 0.32) = 0.05 × 0.68 = $0.0340 (3.40%).
– Issuer receives federal subsidy = 0.35 × 0.05 = $0.0175; issuer net interest cost =
= 0.05 − 0.0175 = 0.0325 (3.25%).
Interpretation: the investor’s after‑tax yield is 3.40% while the issuer’s net borrowing cost is 3.25%. Because the federal government paid 35% of the coupon to the issuer, the issuer could offer a coupon (5.00%) that left the investor with a competitive after‑tax return while still lowering the issuer’s effective cost below what a tax‑exempt municipal bond because the investor would pay no federal tax on the interest; in contrast, BAB interest was taxable to investors but the issuer received the 35% federal payment.
2) Tax‑exempt municipal bond (for comparison)
– Assume a tax‑exempt muni coupon = 3.40% (to give the same investor after‑tax yield as the BAB investor above).
– Investor pre‑tax interest = $0.034 per $1 face.
– Investor after‑tax interest = $0.034 (no federal tax on muni interest).
– Issuer net interest cost = 0.034 (3.40%).
Comparison and takeaway
– Direct‑payment BAB (coupon 5.00%) -> investor after‑tax = 3.40%; issuer net cost = 3.25%.
– Tax‑exempt muni (coupon 3.40%) -> investor after‑tax = 3.40%; issuer net cost = 3.40%.
– Net saving to issuer from using the BAB (vs. issuing a tax‑exempt bond that gave the same investor yield) = 0.15 percentage point per year, i.e., $1.50 per $1,000 face per year.
Assumptions and caveats
– These examples assume the investor can be characterized by a single marginal federal tax rate (32% here) and that the full 35% issuer subsidy is received and retained by the issuer. In practice, investor tax situations vary and the subsidy mechanics (timing, qualifying documentation) introduced operational complexity for issuers.
– Tax‑credit BABs (the alternative BAB structure) gave investors a federal tax credit equal to a percentage of the coupon rather than paying issuers directly; that structure shifted the subsidy to investors and