Demand for Build America Bonds (WSJ)

Investors Push to Extend BABs By ANDREW EDWARDS

The Build America Bond program isn't set to expire until the end of 2010, but portfolio managers and other investors in this new class of taxable municipal securities already are arguing to extend it. The reason: The bonds, known as BABs, have done their job. They have helped states, cities and other local government entities tap new capital markets and lower financing costs.

The credit crisis obliterated much of the demand for municipal debt. Money-market funds lost their appetite for variable-rate bonds, and funds that had borrowed heavily to invest in munis disappeared almost entirely.

Municipalities were forced to delay issuing new debt, or to offer unheard-of rates to attract enough individual investors to fund projects. BABs were meant to change that, and they did: New investors have come to the table and tens of billions of dollars in BABs have been issued.

"BABs are a much better foundation for the muni market," said Peter Coffin, president of Breckinridge Capital Advisors, which has $11 billion in municipal bonds under management. "It's a deeper source of demand."

The question is whether they are worth the long-term cost.

The most popular form of BABs pay higher interest rates than tax-exempt muni bonds and recoup 35% of the interest charge from the federal government. So, if a public university sells BABs with an interest rate of 5%, the university ends up paying only 3.25%, with Uncle Sam's subsidy effectively picking up the difference.

This makes BABs attractive to municipalities, which end up with an actual cost of capital even lower than on traditional tax-free muni bonds. The triple-A rated Virginia College Building Authority recently issued tax-free bonds due in 2027 at a par yield of 4.25%, said Ben Landers, head of taxable municipal-bond sales and trading at investment bank Morgan Keegan in Memphis, Tenn. Similar Virginia transportation BABs yield 5.72%, he said, but the actual cost to the state is 3.71%.

"If you're building something it makes sense to go BABs," Mr. Landers said.

However, that subsidy adds up. Assume that BABs yield an average of 5.95%, the average yield on Wells Fargo & Co.'s BAB index at the beginning of November, and that $48.3 billion of BABs have been issued this year. That means, year to date, the federal government has been put on the hook for $1 billion in yearly interest payments, a number that is only going to increase.

Advocates of BABs said that much of that figure is likely to come back in the form of federal taxes. They said these bonds potentially could end up costing the government less than the tax-free alternative if, and it is a big if, the taxable securities don't end up largely overseas or in the hands of nonprofit groups, pension funds and other institutions that aren't taxable to begin with.

Right now, those institutions shun lower-yielding munis because they don't benefit from the tax exemption on interest. They also are the major source of new demand for BABs.

"We really don't have a group of investor that can't buy BABs," Mr. Landers said. "For tax-free bonds, it's a very finite group of people."

BAB supporters argue that it is a more-efficient subsidy. The increased demand eventually will drive down yields, and the savings will be passed on to taxpayers. This is in contrast to the tax-free bonds, where the full benefits, they said, were never priced in.

Public advocates worry that the increased ease in raising capital could be an invitation to spend the easy money less wisely.

"It's an awful lot of money that's being put into the market without more transparency," said Michael Lakosky, at New York University's Institute for Public Knowledge.

Write to Andrew Edwards at andrew.edwards@dowjones.com