The Economic Recovery and Reinvestment Act of 2009 created a new form of municipal bond that may be worth considering for investors who see a need for a fixed income investment with government backing, but perhaps are not in a very high tax bracket where traditional tax-free municipal bonds provide an advantage.
In brief terms, Build America Bonds, are issued by municipalities such as state governments or agencies. The interest paid to the investor who owns the bonds is not tax-free, as is the case with most municipal bonds. These bonds pay higher levels of interest than traditional municipal bonds, typically in the 6 to 8 percent range, depending on the credit standing of the issuing agency.
The Build America Bonds are issued in one of two forms. In the first, the issuing municipality receives a subsidy from the federal government equal to 35 percent of the interest paid to bondholders. In this case, a bond paying 6.5 percent would only cost the issuing agency 4.23 percent. In the second form, the bond owner receives a 35 percent tax credit against the income received from the bonds. Obviously, bonds issued in the second category will yield less to account for the tax-free portion of the income. Bonds from the first category have been the most popular so far with most of the issues being purchased by institutional investors.
Why would an individual investor consider these taxable municipal bonds for his/her portfolio? I think the primary reason would be earning a yield higher than many corporate bonds with the peace of mind of the backing of the state or local government that issued the bond. A default by a municipality is not out of the question, but is not a frequent event.
Corporate bonds are backed by the credit worthiness of the individual corporation, but investors could lose part of their principal value in the case of a bankruptcy (default). A municipality has taxing authority and can raise taxes to meet its financial obligations.
Keep in mind that while traditional municipal bonds have been advantageous generally for those investors in the top tax brackets, Build America Bonds tend to favor investors in lower tax brackets because of their higher yields, less of which goes to taxes for these investors. Analyzing the after tax yield based in your income tax bracket and then comparing to the yield available on tax-free municipal bonds is the way to decide which one favors your situation.
Invesco PowerShares has brought an exchange traded fund which holds Build America Bonds and allows a diversified portfolio of these bonds to be purchased in one transaction. The fund is called the Invesco PowerShares Build America Bond Portfolio and trades under the symbol BAB. The fund is very new and there was no yield information available as of this writing.
As always, assessing risk is important. If we go on the historically reliable assumption that municipal failures are rare, then the main risk of owning Build America Bonds is the temporary loss of principal value, which occurs for most types of bonds when interest rates rise. Since we are today in a very low interest rate climate, chances are good that at some point in the future rates will rise causing bond values to decline. Of course, this only impacts investors who are forced to sell their bonds before the maturity date, since the bonds will move back to full value as they approach maturity.
Tom Breiter is president of Breiter Capital Management, Inc., an Anna Maria based investment advisor. He can be reached at 778-1900. Some of the investment concepts highlighted in this column may carry the risk of loss of principal, and investors should determine appropriateness for their personal situation before investing.