Build America Bonds (BABs) were a creative financial tool that combined the benefits of municipal bonds with federal tax incentives. Initiated in 2009 as part of an economic stimulus package, BABs played a crucial role in channeling capital into local communities during a time of dire economic need.
Understanding Build America Bonds (BABs)
In the aftermath of the 2008 financial crisis, investor confidence in municipal bonds had plummeted. The federal government introduced BABs to rekindle investment in state and local projects. These bonds were issued by state, municipal, or county authorities to fund capital expenditures like infrastructure developments. What made BABs attractive was the federal subsidies on their interest rates, significantly lowering borrowing costs for issuers.
Furthermore, given the shaky landscape for corporate bonds post-crisis, investors were more inclined towards government-issued securities, thus ensuring a steady flow of capital into local projects.
Types of Build America Bonds
There were two main types of BABs: tax credit BABs and direct payment BABs.
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Tax Credit BABs: These offered a 35% federal tax subsidy on the interest paid through refundable tax credits, reducing the bondholder’s tax liability.
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Direct Payment BABs: Here, the U.S. Treasury provided a 35% subsidy directly to the bond issuer, enabling them to offer competitive interest rates. For instance, California’s early 2009 BABs issued at 7.4% interest rates only required the state to pay 4.8%, with the federal government covering the rest.
Restrictions on Build America Bonds
While BABs were innovative, they weren’t universally accessible. Private parties and 501(c)(3) organizations couldn’t utilize the program. Moreover, the issuance of BABs was restricted to new capital expenditure bonds issued before January 1, 2011, ruling out their use for debt refinancing.
Key Takeaways
- Build America Bonds were taxable municipal bonds that featured federal tax credits or subsidies for bondholders or state and local government bond issuers.
- The program aimed at revitalizing local economies post-financial crisis by making infrastructure investments more affordable.
- Two types of BABs existed: tax credit and direct payment BABs, each offering substantial federal subsidies.
Build America Bonds vs. Traditional Muni Bonds
Traditional municipal bonds offer interest income exempt from federal and some state taxes, unlike BABs whose interest income was federally taxable. The higher after-tax yield made BABs particularly attractive during their existence despite the tax burden.
Related Terms: municipal bonds, subsidies, capital expenditures, default risk, tax credit, cost of borrowing, U.S. Treasury.
References
- Internal Revenue Service. “IRS Releases Guidance on ARRA Bond Provisions”.
- Internal Revenue Service. “Frequently Asked Questions on Build America Bonds and Recovery Zone Economic Development Bonds”.
- Institutional Investor. “Boom in American Bonds”.
- Securities Industry and Financial Markets Association. “Build America Bonds Fact Sheet, Q4 and Full Year 2010”.
- Internal Revenue Service. “Lesson 10 Build America Bonds”, Pages 4, 10.
- Municipal Bonds. “What Are Build America Bonds?”
