Invesco PowerShares is scheduled to launch its Build America Bond Portfolio (BAB) on Tuesday, the first exchange-traded product to offer exposure to a new class of fixed income securities. Build America Bonds are different from traditional fixed income securities in several ways, with the potential to deliver attractive real returns with minimal risk of default to investors.
Build America Bonds are relatively simple securities: taxable bonds issued by state and local governments, with interest from the bonds subsidized by the U.S. Treasury. The Build America Program was introduced under the American Recovery and Reinvestment Act of 2009 with the objective of reducing borrowing costs for municipalities looking to pursue necessary capital projects, such as work on public buildings, courthouses, schools, roads, and utilities.
The U.S. Treasury makes a payment to the issuers of direct-payment Build America Bonds equal to 35% of the total interest payable to investors. So if a municipality issues a $100 million Build America Bond with a taxable coupon of 10%, the issuer would make an annual interest payment to investors of $10 million and would receive a $3.5 million payment from the Treasury, resulting in an effective interest rate of 6.5%. By providing this incentive to make capital investments, the Treasury hopes to stimulate local economies still reeling from the downturn.
Unlike most municipal bonds, Build America Bonds are taxable securities. Taxable municipal bonds have historically delivered yields comparable to similarly rated corporate bonds. According to data from BofA Merrill Lynch and Bloomberg, since 1997 10-year AAA-rated taxable munis have yielded just five basis points less than 10-year AAA-rated corporate bonds.
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Despite this similarity in yields, taxable munis have historically exhibited significantly lower default rates than similarly-rated corporate debt. According to a study completed by Standard & Poor’s, the 10-year cumulative default rate between 1990 and 2008 for all investment-grade munis was just 0.06%, compared to 2.25% for all investment-grade corporate bonds. Moreover, the average recovery rate on defaulted munis has been 68% of par, compared to just 42% for defaulted corporate bonds.
Vital Stats On BAB
In order to be included in the BofA Merrill Lynch Build America Bond Index, securities must have:
- An investment-grade rating
- At least one year remaining until maturity
- Fixed coupons
- Minimum amount outstanding of at least $1 million
- Direct pay federal subsidy
While the actual index will include thousands on individual securities, BAB will utilize a sampling technique to match duration, coupon, and overall return of the benchmark.
BAB will charge an expense ratio of just 28 basis points, making it competitive with both municipal bond ETFs and corporate bond ETFs. The iShares S&P National Municipal Bond Fund (MUB) charges 25 basis points, while the GS $ InvesTop Corporate Bond Fund (LQD) has an expense ratio of 0.15%.
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Disclosure: No positions at time of writing.