What Is a Build America Bond?

A Build America Bond, also known as a BAB, is a new type of taxable government bond created under the American Recovery and Reinvestment Act which was signed into law by President Barack Obama in February 2009. The main objective of this bond is to bring down the cost of issuing government, local, or state bonds. BABs are similar to municipal bonds because they are basically debt securities issued by a county, municipality or state to help fund its capital expenditures. However, unlike in a municipal bond, the income generated from a BAB is taxable. In essence, this type of bond is designed to make it easy for state and federal government agencies to borrow money for capital spending. It is worth noting that some tax-exempt organizations and private party issuers cannot use the BAB program.

Direct Payment Build America Bond

In this type of BAB, the issuer gets a 35% subsidy from the federal government to cover part of the interest paid to investors who bought the bonds. This is important in enabling smaller government entities to issue bonds with interest rates that are comparable to those issued by private corporations. A high interest rate can attract more investors to acquire this type of taxable government debt security.

A Direct Payment BAB may have a large subsidy from the federal government, but it is also subject to restrictions. For one, before the Direct Payment BABs can be eligible for the subsidy, the issuer should submit a payment request form within a specified period. Furthermore, the costs related to the issuance should not exceed 2% of the entire proceeds from the sale of bonds.

Tax Credit Build America Bond


The holders of these bonds will receive from the federal government an annual tax credit amounting to 35% of the bond interest. In the Direct Payment type, the issuer is the recipient of the tax subsidy, but in the Tax Credit type, the bondholders are the ones who will enjoy the tax benefit. Moreover, if the bondholder has a tax liability that is smaller than the entire tax credit, the remainder can be carried over to subsequent years.

Before any government issuer can offer Tax Credit BABs, the bonds must meet certain requisites. However, such requirements are not as stringent as that in Direct Payment BABs. In fact, Tax Credit BABs can be issued in lieu of other tax-exempt government bonds, with the exception of private activity bonds.

Risks Relating to Build America Bonds

Although most of the BABs issued by various states have already been oversubscribed, this type of investment has limited liquidity compared to common stocks. Since these bonds are a fairly new type of security, there is no assurance that a retail investor can offload this type of investment easily. Besides, the maturities for most of the currently issued BABs are about 10, 20, or even 30 years. Lastly, even if retail investors can get their hands on BABs in a secondary market, these bonds are a more appropriate investment for institutional investors.

 

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