What are Build America Bonds?

Build America Bonds (BABs) are specialized bond products issued by municipalities under the American Recovery and Reinvestment Act of 2009. These bonds are taxable, unlike most municipal bonds, and come with incentives from the federal government to make them cost effective for local communities to issue. The goal was to facilitate the ability to raise funds through bond measures with bonds issued between 2009 and 2011. For investors, the taxable nature of BABs created some drawbacks.

Two different kinds of Build America Bonds were authorized. The first is a bond where the government subsidizes part of the interest payment, making the bond cheaper for the issuer by covering part of the pledged interest. The government pays 35% of the interest, while the municipality is expected to cover the remaining 65%. This cuts down on local debt service, making it easier to administer bonds.

Another kind of Build America Bond provides a tax credit to the bondholder in the form of 35% of the earned interest. This option proved less popular with municipalities, as while it provided an incentive for bondholders, it was still expensive for municipalities to issue, as they had to cover all of the interest. A number of municipalities across the United States took advantage of Build America Bonds to raise billions in United States dollars at the time for infrastructure improvements and other activities.

For investors, Build America Bonds were less appealing than tax-exempt bonds, but there were also some misconceptions about this financial product. The involvement of the federal government in the process led some investors to believe that Build America Bonds were equivalent to Treasury bonds, backed by the United States government, when in fact they were susceptible to municipal bankruptcies and other problems. These products tended to be appealing to mutual funds and smaller investors without big income tax liabilities who weren't concerned about incurring some additional tax liability.

Developed as a measure to address the credit crunch accompanying the economic crisis of the early 2000s, Build America Bonds were one among many tools used by the federal government to help local governments stay functional during a period of economic hardship. Some critics feared that debt products like these bonds would expose municipalities to an increased risk of bankruptcy by encouraging them to borrow money rather than balancing budgets and paying down debt. Others felt that such bonds created job opportunities and other benefits for local communities.