Build America Bond ETFs: Crushing The Muni Competition

by on October 26, 2011 | ETFs Mentioned:

This year has, so far, been a pretty strange period for municipal bond investors. It started off with a dire prediction from Meredith Whitney on the market as she stated her belief that we will see a large amount of defaults in the space in the very near future. “You could see 50 sizable defaults, 50 to 100 sizable defaults, more.” said Meredith in December of last year. “This will amount to hundreds of billions of dollars worth of defaults.” While this prediction has not come true– at least not yet– questions are beginning to pop up regarding the market nonetheless. 

In fact, Harrisburg, Pennsylvania, the capital and one of the ten largest cities in the state, recently filed for bankruptcy, although the State is trying to prevent this from happening in order to avoid a wave of defaults. Nevertheless, the situation in the state capital is looking grim; some estimates state that the city owes nearly $242 million and is in default on $65 million in bonds, a pretty sizable sum for a city of less than 50,000 people. This relatively large ordeal is causing concerns to build over the rest of the market and pushing many to wonder if Whitney was just a little early in her predictions of a muni Apocalypse [Are Muni Bond ETFs In Trouble?].

While no one knows for sure if this will be the case in the months ahead, one thing is for sure; muni bond investing has been a pretty good bet in 2011, despite all the turmoil and questions surrounding the market. Of all the products that have been in existence since the start of the year in the Municipal Bonds ETFdb Category only one is down on the year. Furthermore, several of the most popular products in the space, including MUB, TFI, and PZA, have all put up gains of at least 6.5% since the start of the year. These figures match up pretty nicely against some of the shorter-duration products in the Treasury bond world, and given the favorable tax treatment of munis, could offer better yields as well [read Looking For Juicy Yields? Try Municipal Bond ETFs].

Beyond this broad muni craze, however, one unique corner of the market has managed to outperform virtually every other muni sector in year-to-date terms; Build America Bonds. These bonds, also known as BABs for short, fall into the muni category but are classified as ‘taxable’, unlike most other funds in the space. This means that investors generally have to pay local taxes on these funds but the government steps in and gives municipalities a 35% subsidy to help cover costs. This allows these local governments to boost interest rates to match their taxable counterparts at no cost to them, making them extremely competitive in terms of yield [see Better-Than-AGG Total Bond Market ETFdb Portfolio]. In essence, local governments save on funding costs while investors still get high yielding securities; both sides win in the BABs market.

Although no new issuance of these types of securities has taken place since the program was shuttered at the end of 2010, demand has been so robust that the three products in the space have outperformed their ‘regular’ muni counterparts by nearly 500 basis points in the year-to-date time period. While this may seem puzzling given the concerns over public finances across the nation and sporadic threats to defund the program, there are actually a few good reasons for BABs’ outperformance so far in 2011.

The first reason has to do with the lack of supply in the marketplace. Issuance of taxable debt has been pretty much non-existent so far in 2011, making BABs one of the few choices for investors looking to play this asset class. Since no new supplies have hit the market in the BABs space for quite some time, and no new issuance looks to be taking place any time soon, investors have been forced to bid up the price of these securities in order to gain access to the space [see Using ETFs To Build A Complete Bond Portfolio].

Secondly, the shift of the yield curve has also benefited this market as well. When yields are slumping and default rates remain low, investors often pile into munis as a way to capture more yield with minimal additional risk [see 25 Dividend ETFs For Yield Hungry Investors]. “Municipal bonds tend to underperform taxable bonds when U.S. Treasuries rally, and this has been the case in recent months.” said Joe Becker, Product Strategy Manager at Invesco PowerShares, suggesting that continued compression of the yield curve could be good news for BABs in the months ahead as well.

Lastly, in order to take advantage of cheap funding over the long term, many cities and states issued long term bonds that aren’t due for several decades. Since interest rates have pretty much collapsed across the board, these longer term securities, no matter if they are in the muni, Treasury or corporate bond space, have benefited greatly in terms of capital appreciation. BABs are no different in this scenario and this focus on longer term bonds has also likely been one of the key reasons for their outperformance over the past few months [Compare BAB ETFs with the ETF Comparison Tool].

So for investors looking to gain access to BABs ETFs, there are three quality choices available. Below, we highlight these three funds and discuss some of the key points that investors should remember when considering which one may make sense for their portfolio:

PowerShares Build America Bond Fund (BAB)

This fund from PowerShares is by far the most popular on the list with assets under management of close to $670 million and volume of close to a quarter million shares a day. The fund tracks the BofA Merrill Lynch Build America Bond Index which is designed to track the performance of U.S. dollar-denominated Build America Bonds publicly issued by U.S. states and territories, and their political subdivisions, in the U.S. market. Nearly half of the bonds in the fund mature in 25 years or more while another 45% have at least 15 years to maturity, giving the product a decidedly long-term tilt [see BAB Holdings]. Furthermore, with a SEC 30 Day Yield of just under 5% and an expense ratio right around 30 basis points, the product looks to be a decent yield option for investors as well. In terms of performance, BAB has slipped a little over the past few weeks but in year-to-date terms, the product is still up 12% [September's ETF Studs: Five Funds That Thrived During A Wild Month].

SPDR Nuveen Barclays Capital Build America Bond ETF (BABS)

BABS is State Street’s entry in the space, tracking the Barclays Capital Build America Bond Index. This benchmark consits of all direct pay BABs that satisfy the rules of the Barclays Capital Taxable Municipal Index. In total, the fund holds roughly 152 securities with heavy exposure going towards California (34%), New York (16.6%) and Texas (11.2%). In terms of maturity levels, the vast majority of the product consists of securities that mature in between 20 and 30 years although shorter term securities make up another 10% of the fund. Beyond 30 year bonds, the fund actually has close to one-fourth of its portfolio in securities that don’t mature until at least 2041 giving the fund an average years to maturity of 27.7 years [see BABS Holdings]. Thanks to this focus on longer term securities, BABS has put up a solid performance level in year-to-date terms, adding close to 13% while paying out a yield of roughly 4.6% to investors [see The Wide World of Muni Bond ETFs].

PIMCO Build America Bond Strategy Fund (BABZ)

This PIMCO fund is an actively managed choice for investors in the BAB space, as the product does not track any particular index. This gives the fund more flexibility, but less diversification as BABZ only has 28 securities in total in its portfolio [see BABZ Holdings]. However, much like the other products in the space, it is heavily tilted towards longer term securities with close to 63% of assets maturing in at least 20 years from now. In fact, the average fund maturity is close to 24.1 years, putting it in line with other BAB funds in the space. For investors wondering if the active management has paid off, it looks like it has in this case, as the year-to-date return is just over 15%, along with a yield of just over 4.9% in 30 Day SEC yield terms [see more on the BABZ Fact Sheet].

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Disclosure: No positions at time of writing.