(FOX Business News) – In case you haven’t noticed, there are BABs in Bondland.

“Build America Bonds” were created by Congress under The American Recovery and Reinvestment Act passed last year.(1) They’re municipals with a twist: unlike traditional bonds issued by state and local governments, the interest on BABs is taxable instead of tax-free. As you might expect, this makes them pretty unattractive to typical muni investors, that is, folks in the top tax brackets looking to avoid losing more than a third of the interest earned to federal income tax.

None-the-less, non-traditional buyers, those who pay no or little federal income tax, are snapping them up.

Craig Brandon, manager of Eaton Vance’s Build America Bonds mutual fund, says BABs have created “a whole new market” of municipal-bond investors, including pension funds, foreign governments and corporations, as well as individual investors in the lower tax brackets.

To make it more affordable for cash-strapped cities and states to take on new debt, the federal government is picking up part of the interest- a total of 35-percentage points.(2) Thus, if the interest on a BAB is 5%, the cost to the issuer is 4.65% (5.00%-.35%). The investor, of course, receives the full 5%.

According to Mallas, approximately $121 billion of BABs have been issued since the first one came out in April 2009. By law, the money raised must be used to fund construction projects; fulfilling the goal of “stimulating” the economy by creating jobs.

So what’s not to love?

For one thing, just because the federal government is subsidizing the interest payments, don’t confuse a BAB with a Treasury bond.

“We’re hearing that retail investors think this is security guaranteed by the U.S. treasury or U.S. government,” says Mallas. “It’s not.” Neither the interest payments nor the return of principal are guaranteed, although he stresses that the municipal bond market has historically had a very low default rate.

Brandon maintains that, despite the fact that state and local governments are grappling with the worst budget shortfalls in history, it’s unlikely we’ll see a surge in defaults.

Take the extreme case: California. “If you’re the state of California, [defaulting] only gets you $5-6 billion… when you have a $20 billion hole,” Mallas says. “If you eliminate 100% of California’s debt, hat only solves 25% of its deficit problem. They have a spending problem, not a debt problem.”

Both managers assert that for investors who don’t need tax-exempt income, BABs offer a way to diversify bond holdings and potentially reduce your overall risk. Although T. Rowe Price doesn’t have a mutual fund specifically devoted to Build America Bonds, Mallas says they are held by some of the firm’s taxable bond funds.

In addition, BABs might pay you higher income than a corporate bond with a similar risk rating. Brandon points to an A1-rated state of Illinois BAB issued last week with a yield of 7.11% and a maturity date of 2035. By comparison, an Abbot Labs corporate bond due in 2039 and trading in the secondary market has the same rating but a yield of just 5.16%.

He adds, “I’m not saying ‘Sell all of your corporate bonds.’ [I’m suggesting you] diversify some risk [by moving into] the muni market and picking up a little more income.”

Next week: BABs are not without controversy. Unless Congress acts, the federal subsidy- and, thus, the issuance of new BABs- expires at the end of this year. Why you might be glad if that happened did.

Read More…

(Investor’s Business Daily) – Bondholders are saluting Build America Bonds. States, cities and others sold $120.5 billion of the taxable munis as of July 16 since their April 2009 inception, says Municipal Market Advisors.

They sold $66 billion in 2009. That puts this year’s issuance on track to outstrip their debut-year pace.

BABs were devised by the federal government to help municipalities bounce back from the worst recession since the Great Depression.

Traditional munis plunged in free fall in 2008, during the credit crisis. Hedge funds and banks were especially heavy sellers.

“Those big money investors needed to raise cash,” Brandon said. “And munis were fairly liquid assets.”

As bond investors fled to Treasuries, states and cities were unable to sell munis.

So the federal government let muni issuers sell taxable bonds, and it would reimburse issuers for 35% of issuers’ annual interest payments. That enabled issuers to slash their interest costs.

“It burned after-tax yield way down,” Brandon said.

These non-tax-exempt munis appeal for several reasons, says Craig Brandon, a manager of $29 million Eaton Vance Build America Bond Fund .

One is that they offer fixed-income investors a way to diversify.

Another appeal is the low credit or default risk, which BABs share with traditional munis, coupled with relatively high yield.

“Default risk has been greatly overblown by the media,” Brandon said.

Budget woes of some states and cities do not translate into high odds of default, he says. “It’s low vs. the risk for corporate bonds,” he said.

Of 54 muni defaults since 1970, only three involved general obligation bonds, says Moody’s Investors Services. But 42 involved entities such as private developers of housing and health facilities. Any interest payments may hinge on project income, not taxes.

So look before you leap. Muni risk soars in certain categories.

Read More…