Build America Bonds Are Municipal Bailouts
Bond investors have been all over the new Build America Bonds as created by the 2009 economic stimulus package, and it should be no surprise that American cities are as well. The new bonds allow for the Federal Government to subsidize the interest expense on new projects funded with debt, and cities are sure to grab as much of the subsidies as they can.
How Build America Bonds Work
Build America Bonds were created from a provision in the economic stimulus bill to subsidize the cost of borrowing for American municipalities. Through the program a city can borrow on its own behalf and receive a subsidy worth 35% of the interest expense directly from the Federal government. The bonds are only backed by the full faith and credit of the municipality, not the nation, but have proven to be incredibly profitable for investors and localities.
For localities, the Build America Bond issues allow the city to borrow inexpensively thanks to the 35% subsidy—as if rates weren’t low enough already. For investors, the bonds provide more security that the bonds will be repaid, despite the fact that only a handful of municipalities have ever gone bankrupt.
Business Cycle Theory
One of the ugly parts about the Build America Bonds is that cities are likely to use the bonds to fund highly unproductive projects. With even lower rates, even the most unproductive, and low yielding, investments are profitable. With most munis borrowing at 4% per year, the subsidy drops the actual cost to 2.6%. Now, should the bonds be paid off on time, and be paid off without further borrowing, this isn’t a problem. However, should municipalities have to borrow again to cover the cost, they’ll pay more to finance the debt thanks to a lost subsidy and rising interest rates. What happens then? Their projects start losing money due to higher financing costs. Not good, and I’m sure many cities will run into this problem since most are already running unbalanced budgets.
Get In on the Action
Want in on Build American Bonds? Try this ETF: Build America Bond Portfolio (BAB). The fund tracks the new bonds and does so with a low .28% annual fee.
