Build America Bonds (BABs)

Published Aug 6, 2023

Definition of Build America Bonds (BABs)

Build America Bonds (BABs) are a specific type of municipal bond issued by state and local governments in the United States. These bonds are used as a means of financing public projects, such as critical infrastructure, schools, hospitals, and other essential facilities. What sets Build America Bonds apart is that they are taxable bonds, unlike traditional tax-exempt municipal bonds. However, they come with a unique feature – a federal subsidy provided by the U.S. government.

The primary objective of issuing Build America Bonds is to make borrowing more affordable for state and local governments, thereby encouraging them to undertake vital public projects that may have been financially challenging with traditional financing methods. The federal subsidy is designed to incentivize issuers and attract investors to participate in these bonds, which, in turn, facilitates the financing of public projects with greater ease.

Example

To better understand how Build America Bonds work, consider an example where the state of California issues a $100 million Build America Bond. The bond has a maturity period of 10 years, during which the state will repay the full principal amount. The bond carries an annual coupon rate of 5%, which implies that the state is obligated to make annual interest payments to bondholders based on this rate.

In this case, the federal government agrees to provide a subsidy to support the interest payments on the bond. The subsidy amounts to 35% of the total interest payments, which translates to $3.5 million per year. So, every year, the federal government directly pays the state of California $3.5 million to alleviate a significant portion of the interest burden.

Investors, on the other hand, purchase these Build America Bonds and receive the full 5% coupon rate. Even though the federal government subsidizes part of the interest payments, investors still benefit from a reliable income stream based on the bond’s coupon rate.

Why Build America Bonds Matter

Build America Bonds play a crucial role in financing public projects and stimulating economic growth in the United States. By providing a federal subsidy, these bonds become more appealing to investors, leading to increased demand in the bond market. This heightened investor interest allows state and local governments to borrow funds at lower interest rates, reducing their overall borrowing costs.

The lower borrowing costs, in turn, enable state and local governments to undertake essential infrastructure projects that might have otherwise been economically challenging. These projects create jobs, enhance public services, and contribute to the overall development of communities.

Furthermore, Build America Bonds serve as a bridge between public funding needs and private investors seeking reliable income sources. Investors, seeking a blend of safety and taxable income, are attracted to these bonds due to their backing by state and local governments and the added security of the federal subsidy.

In summary, Build America Bonds provide a win-win situation, benefiting both state and local governments by facilitating crucial public projects and offering investors an attractive investment option with a potentially positive impact on local economies.