Build America Bonds (BABs) emerged as a pivotal financial instrument in the wake of the 2008 financial crisis, aimed primarily at energizing the economy and supporting local infrastructure projects. In this article, we delve into the intricacies of BABs, explore their structure and function, and compare them with traditional municipal bonds.

What Are Build America Bonds?

Introduced in 2009 under President Barack Obama’s American Recovery and Reinvestment Act (ARRA), BABs were taxable municipal bonds designed to support state and local governments in funding essential capital projects. These bonds featured federal tax credits or direct subsidies, making it financially easier for municipalities to issue debt despite lingering post-crisis economic fears. The program was short-lived, expiring in 2010, yet it played a critical role during a period of severe economic uncertainty.

Objective of BABs

The fundamental goal of BABs was to encourage investment in local projects and stimulate job creation. Following the Great Recession, many investors were hesitant to place their funds into municipal bonds, largely due to concerns about default risks similar to those faced in corporate bonds. BABs were a tool to restore confidence and provide municipalities with lower borrowing costs, essential for funding infrastructure developments like roads, bridges, and schools.

Structure of Build America Bonds

The BAB program offered two main types of bonds that catered to different investing strategies:

  1. Tax Credit BABs: These provided bondholders with a 35% federal tax credit on interest payments, effectively lowering their tax liability. If the bondholder's tax bill did not allow for the complete utilization of the credit, they could carry it forward to future tax years.

  2. Direct Payment BABs: Unlike tax credit BABs, these directed the subsidy payments from the U.S. Treasury to the bond issuer, providing them a 35% subsidy on the interest they owed bonded investors. This significantly reduced the net borrowing costs for states and municipalities, allowing for competitive interest rates in the marketplace. For example, California issued BABs in 2009 with an interest rate of 7.4%, but the state's effective rate dropped to 4.8% after government subsidies.

Target Audience and Limitations

The BAB program was specifically designed for new capital expenditure bonds and could not be utilized for refinancing existing debts. Notably, private party issuers and 501(c)(3) organizations were excluded from eligibility. The emphasis on infrastructure over refinancing was deliberate, reflecting the need for tangible improvements in community services amidst economic stagnation.

Comparison: Build America Bonds vs. Traditional Municipal Bonds

An essential distinction between Build America Bonds and traditional municipal bonds lies in their tax treatment. While interest income from standard municipal bonds is typically exempt from federal and some state taxes, income earned from BABs is fully taxable at the federal level. This difference made BABs a less attractive option for some investors initially, despite their higher yield potential due to the subsidy structure.

Impacts of Build America Bonds

While the BABs program only lasted a brief period, its impact was significant. It played a crucial role in financing over $181 billion in total bond issues, facilitating an array of local projects that might have otherwise been stalled due to funding difficulties. Furthermore, these projects helped sustain and create jobs during a time of economic distress.

Conclusion

The Build America Bonds program was a critical response to the economic challenges following the 2008 financial crisis. By offering innovative financing options combined with substantial federal support, BABs provided states and municipalities a vital lifeline that helped stimulate local economies and infrastructure investments. While the program has since expired, its legacy continues to influence public finance and infrastructure discussions in the United States, reminding policymakers of the importance of flexible financial instruments in times of economic distress.