The Build America Bond program often reminds me of the Packard Motor Company; unique, innovative, and put on the shelf far too soon.

In case you missed them, Build America Bonds [BABs] were a special issuance of federally subsidized municipals bonds offered under the American Reinvestment & Recovery Act of 2009. Typically lost in the $3 trillion muni market, BABs have made the news lately for their potential to be negatively affected by sequestration.

In this article, I’ll summarize the major hypothesis as to why investors haven’t reacted to sequestration, and make the case for why BABs are still an interesting alternative to traditional munis. I’ll also breakdown 5 unique funds in which you can still find BABs.

Building a Nation

Since BABs are a unique instrument, and investors should take some time to understand their history.

In the wake of the slowest economic growth since 1930, the Build America Bond Program was part of a larger jump-start known as the Stimulus Package. It kicked off in April of 2009 to moderate attention. The program was issuing a respectable $5.8B a month, however, as issuers and buyers became more familiar and comfortable with the program’s specifics, it would grow in momentum faster than even the Treasury anticipated. The program was stopped on Dec. 31, 2010. In that final month, BABs were making up one-half of all new municipal bond issues. As evident in the map below, I believe many states actually weren’t able to issue BABs fast enough:

In total, the BAB Program brought in a whopping $181B from both domestic and foreign interest. The reasons for this program’s accelerating popularity were three-fold:

Higher Yields Than Traditional Munis: Tax Advantaged

BABs came in two flavors: Direct Payment, which provide a 35% federal subsidy to the interest paid by the bond issuer; and Tax Credit, which subsidize a portion of the tax owed by the bondholders. All of the 5 funds we’ll talk to later hold both flavors.

Regardless, both issuances significantly decreased the borrowing costs for issuing agencies and vastly improved the efficiency in which issuers were able to work with the Treasury. In total, the Treasury estimates issuers saved over $20B in costs versus traditional tax-exempt bonds.

The net result is BABs are able to offer a higher coupon, and even potentially longer maturities, than their municipal counterparts. Recently, BABs have pulled in

6% more annually in pre-tax yield:

BABs Bring In A Broader Investor Group

Its well known that the tax-exempt status of traditional munis most benefits the retail investor, in fact 70% of all traditional muni holders are individuals or mutual funds. Historically this has limited institutional and foreign interest since there would be no major benefit for these groups over corporate bonds or equities.

The structure of BABs, however, allows the tax benefits to fall back to the issuer. The issuers can then return these benefits to their holders, theoretically offering a higher final yield than would have been generated by tax-exempt munis. BABs essentially offered a 35% federal subsidy of the interest paid on American projects, to the world. This never before opened door flooded the BAB Program with new money. Before the fiscally conservative amongst you cry foul, note the Treasury reports the BAB program has already paid for itself.

Quickly Normalized Underwriting Fees

When BABs first hit the market both Wall St. and investors were uncomfortable with many of the programs ins and outs. Additionally many underwriters likely incurred start-up costs which added to this new burden. Initially investors called the fees on BABs exorbitant and stuck with what they knew. By November of 2009 however, BAB underwriting fees had receded to those of traditional munis. Around the same time the Treasury reminded investors underwriting fees are a one time cost, while the tax advantage of BABs would be realized every year. Resultingly, the program exploded.

For more information on the program’s history, the Treasury has prepared a great report .

BABs & Sequestration

While all of these facets of BABs probably have you drooling there is one large dark cloud over the BAB nation. In Congress’ wise wisdom, by Sept. 30th of this year the federal government will make $85B in spending cuts, including cutting the 35% subsidy to

32%. As part of the sequester the Treasury will also need to update their computers, delaying BABs payments for 3-6 weeks. Analysts from Nuveen to UBS felt that BABs would take a hit last month when the cuts began.

However something different happened.

Though the federal subsidy on BABs will inevitably be cut, investors noted those cuts will fall back to the issuers. Since these issuers still have an obligation to pay their interest, BABs holders won’t see any immediate loss of income. Of course, this raises the default risk for BABs, if issuers can’t redirect revenue from other sources into paying their BABs, investors could be in for a surprise.

Luckily, most municipal bonds have a low rate of default to begin with. Since most tax-exempted bond projects don’t generate revenue instantly anyway, issuers are familiar with making high payments on projects with long horizons. Its likely, given the uncertainty surrounding a new bond program, issuers also planned for added contingency in setting their rates.

At the same time, increasing revenue and a recovering real estate market has padded the coffers of most issuers, allowing some breathing room in re-balancing their budgets.

With much of the sequestration dust settling, most BAB holders have decided to stick with it. They believe issuers will simply be able to shoulder the loss. As a result, since sequestration began March 1st, BABs have outperformed traditional munis by an entire percent. For those looking to get onto the Build America bandwagon, try one of these five funds:

5 Funds to Build America

PowerShares was the first to jump on the Build America bandwagon, forming the longest running ETF with the largest number of issuances. The fund tracks the Bank of America Merrill Lynch Build America Bond Index; and in my opinion most accurately tracks what a typical BAB-bond would equate to.

Nuveen’s fund takes a remarkably different approach. NBB is a Closed-End Fund which limits the available shares at IPO. This approach does however enable them to take advantage of leveraging. While this provides the potential for greater return it also increases volatility. Since there have been no new issuances of BABs Nuveen has made clear their fund will terminate around 6/30/2020 when they will distribute the funds assets.

BlackRock’s fund is quite similar to NBB in structure, utilizing a fairly large mix of highly leverage assets. Unlike NBB, BlackRock has continually delayed any contingent review provisions since the cancellation of the BAB program; however they do still reserve the option. If the plan is to continue the fund, BlackRock can choose to convert the funds assets into similar classes; likely high yielding munis.

PIMCO’s BABZ is probably the most unique amongst our five. The fund maintains an actively managed small portfolio of select bonds which objects to . [avoid] securities from municipalities that PIMCO believes face deteriorating credit quality. The fund was only recently formed on Nov. 2nd of last year so accurate projections and analysis are still speculation at this point. Given the fund’s objective is to avoid risky issuers in an environment of historically good issuers, this might be one to keep an eye on.

Guggenheim was the latest to the BABs game, however their CEF has quickly risen to competition with Nuveen’s and BlackRock’s leveraged products. Expect to see variations in these three funds’ portfolios and leverage strategy put on a wonderful struggle for yield.

Build America Bond Funds Summary