Build America Bonds (BABs) are a type of taxable municipal bond issued by state and local governments in the United States. These bonds were created as part of the American Recovery and Reinvestment Act (ARRA) of 2009 to stimulate economic growth during the Great Recession. The purpose of issuing BABs was to provide an alternative financing option for state and local governments to fund infrastructure projects and other capital expenditures.

Features of Build America Bonds

1. Taxable Nature: Unlike traditional municipal bonds, which are tax-exempt, Build America Bonds are taxable securities. Investors who hold these bonds are required to pay federal income tax on the interest income they receive.
2. Direct Payment Option: Instead of the traditional tax-exempt interest payments, issuers of BABs have the option to receive a direct subsidy from the U.S. Treasury equal to a percentage of the interest paid to bondholders. This subsidy helps reduce the borrowing costs for state and local governments.
3. Maturity Period: Build America Bonds typically have longer maturity periods compared to regular municipal bonds, often ranging from 10 to 30 years.
4. Coupon Rates: The coupon rates on BABs are generally higher than tax-exempt municipal bonds to compensate investors for the taxable nature of the interest income.
5. Infrastructure Projects: The proceeds from the issuance of Build America Bonds are primarily used to finance infrastructure projects, such as building roads, bridges, schools, airports, and other public facilities.

Benefits of Build America Bonds

1. Lower Borrowing Costs: The direct subsidy from the U.S. Treasury allows state and local governments to borrow at lower interest rates, reducing their overall borrowing costs.
2. Attracting Investors: The taxable nature of BABs makes them attractive to a broader range of investors, including pension funds, foreign investors, and individual investors in higher tax brackets.
3. Greater Flexibility: By issuing taxable bonds, state and local governments can use the funds for a wider range of projects, as there are no restrictions on the type of projects financed.
4. Economic Stimulus: Building and improving infrastructure through the issuance of BABs can stimulate economic growth, create jobs, and enhance the overall quality of public services.

Risks of Build America Bonds

1. Interest Rate Risk: Like all bonds, BABs are subject to interest rate risk. If interest rates rise, the market value of existing bonds may decline, potentially leading to capital losses for investors.
2. Credit Risk: The creditworthiness of state and local governments issuing BABs is a significant factor in their performance. If an issuer faces financial difficulties, it may affect the bond's ability to meet interest and principal payments.
3. Liquidity Risk: The liquidity of BABs can vary depending on market conditions and the creditworthiness of the issuer. In times of market stress, it may be challenging to find buyers for these bonds.

Taxation of Build America Bonds

1. Federal Income Tax: The interest income from Build America Bonds is taxable at the federal level. Investors must include the interest payments on their federal income tax returns.
2. State and Local Taxes: Although the interest income from BABs is subject to federal income tax, it is typically exempt from state and local taxes in the issuing jurisdiction. This feature can make BABs more appealing to investors in high-tax states.

Conclusion

Build America Bonds (BABs) offer state and local governments an alternative financing option for funding infrastructure projects and other capital expenditures. By providing a direct subsidy to issuers, BABs help reduce borrowing costs and attract a broader range of investors. The taxable nature of these bonds makes them suitable for investors in higher tax brackets and those seeking higher yields. However, like all investments, BABs come with certain risks, including interest rate risk, credit risk, and liquidity risk. Investors considering investing in BABs should carefully evaluate the creditworthiness of the issuing entity and their own risk tolerance. Overall, Build America Bonds have been an essential tool in supporting economic growth and improving public infrastructure in the United States.