What are Build America Bonds?
A Build America Bond (BAB) is a type of municipal bond created under the American Recovery and Reinvestment Act of 2009. Similar to other municipal bonds, BABs are issued by state, local, and county governments to finance capital improvements, governmental expenditures, and local projects. Unlike municipal bonds which are typically exempt from federal income taxes, BABs are taxable. For state and local income tax purposes, BABs are similar to other municipal bonds in that they are generally exempt from state and local taxes (especially if you live in the state where the bond was issued).
One of the key differences between BABs and other municipal bonds is that they are subsidized by the federal government. These federal subsidies are intended to help create jobs and make it easier for state and local municipalities to borrow money to fund local construction projects. From an investor’s standpoint, the federal subsidizes should translate into higher coupon rates offered by the issuers when compared to the rates offered on other municipal bonds.
There are two types of BABs. The issuer (i.e., state or municipality) determines which type is offered prior to issuing the bond. The first type of BAB provides the investor with a tax credit. In this case, the investor receives a 35 percent federal tax credit on the total interest earned on the bond. The second type of BAB provides the issuer with a direct subsidy. The federal government will pay the issuer a 35 to 45 percent subsidy of the interest paid to investors depending on the type project underlying the bond. While the second type of BAB results in a higher subsidy to the issuer, the costs and restrictions associated with issuing these “direct payment BABs” are higher.
For investors, BABs may be an attractive option over other municipal bonds depending on your tax bracket. If your tax bracket is greater then 35, a tax credit BAB may not yield any tax advantage over other tax-exempt municipal bonds. However, if your tax bracket is less than 35 percent, a tax credit BAB may offer some tax advantages.
In addition to weighing the tax implications associated with investing in BABs (and other municipal bonds), there are other important factors to consider before investing. Investors should make sure they fully understand the following before investing:
- The type of investment, the role it plays and the role it is intended to play in your overall portfolio;
- The effect of interest rates on the investment;
- The after-tax yield of the bond;
- The risks associated with the investment;
- The credit worthiness of the issuer of the investment;
- The features and characteristics of the investment;
- The potential lack of liquidity associated with BABs.
For more information on BABs and the bonds that have been issued to date (by each state) please read the U.S. Treasury’s latest update at http://www.ustreas.gov/press/releases/tg221.htm
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