A bond is a contract to repay borrowed money within a specified term and with fixed-interval interest payments. Build America Bonds (BABs) were created under the American Recovery and Reinvestment Act. signed into law by President Obama in February 2009, with the intention of providing a low cost means of borrowing for state, municipality and county agencies. Build America Bonds are taxable fixed-income securities that help these agencies finance capital expenditures through subsidized borrowing. There are two types of Build America Bonds: Direct Payment and Tax Credit.

Direct Payment BABs

Direct Payment BABs provide issuers with a federal government subsidy to assist with interest payments owed to bond purchasers. The subsidy is equal to 35% of the interest, substantially reducing the borrower’s burden for interest payments. This means that issuers can borrow money (by issuing bonds) at a reduced, government-subsidized cost. (Want to learn more? Don’t miss Investing In The Recovery With Build America Bonds .)

Tax Credit BABs

Tax Credit BABs provide tax credits for bond holders equal to 35% of the interest earned each year on the bonds. Tax credits can be carried forward to future years when the credit does not immediately provide a financial benefit. Both Direct Payment and Tax Credit BABs reduce the costs associated with borrowing for states, municipalities and counties.

The Real Deal: Pros and Cons

Build America Bonds are a relatively new type of debt security with an uncertain future — they may be available perhaps only until the end of 2010. In addition to — and despite — the obvious benefit to state and local agencies in need of money, numerous pros and cons surround these controversial bonds.

The Pros

• 35% subsidy/tax credit
• Interest rates comparable to corporate bonds — this means the bonds are typically high-yielding
• Allow municipalities to raise money for capital expenditures
• Provide bond-holders with a long-term (30-year) stable source of income
• Create new jobs as capital projects are funded
• $106 billion in Build America Bonds has been issued, constituting approximately 21% of the municipal bond market (as of May 31, 2010).

The Cons

• Wall Street has been criticized for charging higher-than-average fees and commissions for BABs at the start of the program, thereby increasing borrowing costs.
• The future of the BABs program is uncertain; it may end December 31, 2010.
• Subsidies may not be available to state and local governments owing money to the federal government for such programs as Medicaid.
• Taxpayers foot the bill for the interest subsidies. There is some argument that taxpayers are essentially bailing out those states with the largest debt and BABs deals (such as California and New York).

The Bottom Line

Bonds have long been used to finance government and local projects. Build America Bonds were created to help state and local governments recover following the economic downturn of 2008. Though the BABs market typically involves the big players (such as large insurance companies), individual investors can now trade Build America Bonds ETFs (NYSE:BAB ), a trading instrument with increasing popularity. (Discover the advantages of a security that tracks bond index funds but trades like a stock in Bond ETFs: A Viable Alternative .)

The Build America Bonds program, while under scrutiny for being a taxpayer burden and another way for Wall Street to make an extra buck, has been an important tool for state and local governments to finance capital expenditures with a lower-cost borrowing option. In addition, the program has evolved to form a significant portion of the municipal bonds market, providing low-risk investment opportunities for firms and individuals, with higher-than-average returns.