PowerShares Plans Another Build America Bond ETF (BABI)

by on June 8, 2010 | ETFs Mentioned:

Encouraged by the impressive start to the first ETF offering exposure to Build America Bonds, PowerShares recently filed details on a second, more targeted fund within the same asset class. The latest proposed addition to the PowerShares lineup is the Intermediate Build America Bond Portfolio, a product that would track the BofA Merrill Lynch 1-12 Year Build America Bond Index. That benchmark represents a subset of the broader universe of taxable municipal securities eligible to participate in the Build America Bond program, consisting of those with between one and 12 years remaining until maturity.

The PowerShares Build America Bond Portfolio (BAB) launched in November 2009 and now has nearly $350 million in assets, making it one of the most successful ETF launches in recent memory. State Street launched a competing product last month in the SPDR Nuveen Barclays Capital Build America Bond ETF (BABS), and PIMCO has an actively-managed Build America Bond fund in the works. So the space is getting very crowded very quickly, an indication of the tremendous interest in these securities as a portfolio holding. It’s estimated that eligible governments have issued more than $100 billion in Build America Bonds since they were introduced a little over a year ago as part of the American Recovery and Reinvestment Act of 2009 (see all ETFs in the Municipal Bonds ETFdb Category).

Unlike most municipal bonds, Build America Bonds are taxable securities, eliminating one of the advantages that has traditionally allowed municipalities to issue debt at lower rates than otherwise comparable corporate debt. Here’s the unique element of Build America Bonds: 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%.

Unique Exposure

The proposed PowerShares product would be very different from the two existing Build America Bonds currently available to U.S. investors. BAB tracks the BofA Merrill Lynch Build America Bond Index, and less than 5% of the fund’s holdings have a maturity of less than 15 years (more than 70% of assets have at least 20 years remaining until maturity). BABS tracks the Barclays Capital Build America Bond Index, a benchmark similarly dominated by debt issues maturing in 2030 and beyond (see a breakdown of BAB holdings and BABS fact sheet).

So the proposed BABI would have a much shorter effective duration than either Build America Bond product currently out there, making it an interesting alternative for investors concerned about the prospects of rising interest rates.

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Disclosure: No positions at time of writing.