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States, cities and investors love Build America Bonds. But what about that 35% subsidy?
Forbes.com - Nov. 3, 2009 - by Matthew Craft
The Obama administration's support for local government debt was launched in the thick of the credit crunch, as an effort to keep debt markets open to municipalities. In that, it succeeded: states and cities have relied on the Build America Bond program to sell more than $47 billion in bonds since March. But it's an expensive and questionable subsidy, said Philip Condon, head of municipal bond management at DWS Investments, the asset management arm of Deutsche Bank. He expects the support to get trimmed.
Unlike other muncipal debt, Build America Bonds are taxable. They pay a higher interest rate than tax-free municipal bonds but are a cheaper form of borrowing for cities and states, because the federal government picks up 35% of the interest payments. The support has come in especially handy for cash-strapped California, which has sold more than $7 billion. The state is currently marketing $908 million of the bonds in a sale managed by Citigroup ( C - news - people ).
Congress will likely extend the program before it expires at the end of next year, Condon said at a recent lunch with the media. But he said he represents many in the bond markets in believing the 35% subsidy is too high. "BABs are costing the government a lot of money," he said.
Similar to the guaranteed bank debt from Goldman Sachs ( GS - news - people ), Bank of America ( BAC - news - people ) and General Electric ( GE - news - people ), Build America Bonds offer investors low-risk government backing at a higher yield than Treasurys. They've attracted foreign buyers who want something besides Treasury debt and mortgage-backed securities into the municipal market, said Marilyn Cohen, president of Envision Capital Management in Los Angeles and a Forbes columnist.
Issuers "are taking the money and running," Cohen said. She sees signs posted next to construction sites in California heralding the American Recovery and Reinvestment Act of 2009 – the official moniker for the stimulus package – and Build America Bonds.
The bonds typically have long maturities, from 20 to 30 years, which works well for pension funds attempting to match their obligations to pay workers retiring in future decades. But they pose more of an interest-rate risk to other investors, said Matthew MacDonald, a DWS portfolio manager for retail fixed-income funds. When interest rates rise from their historic lows, bonds with the longest maturities are likely to get hit the hardest. That's one reason MacDonald said he's staying away from them.
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