Build America Bonds

Build America Bonds (BABs) were a temporary federal program (2009–2010) that created taxable municipal bonds with a federal subsidy. They were designed to help municipalities finance infrastructure when the tax-exempt bond market struggled. While the program ended, some BABs remain outstanding and illustrate how tax exemption drives municipal bond yields.

Key takeaways

• Build America Bonds were issued 2009–2010 under the American Recovery and Reinvestment Act (ARRA) as economic stimulus
• Unlike traditional munis, BABs were fully taxable to investors, but the issuer received a federal subsidy (35% of the coupon)
• The subsidy offset the tax burden, making BABs attractive to investors who could not benefit from tax exemption
• Tax-exempt institutions (like pension funds and universities) could earn higher taxable yields on BABs
• The program ended in 2010 due to budget concerns; few BABs remain outstanding, but understanding them clarifies the value of tax exemption

The 2009 context: crisis and stimulus

In 2009, the municipal bond market was under stress. Lehman Brothers' collapse (2008) and the financial crisis froze credit markets. Municipal issuers faced rising borrowing costs and declining demand for bonds. Schools, states, and cities urgently needed capital for infrastructure but faced a hostile financing environment.

The Obama administration, as part of the American Recovery and Reinvestment Act (ARRA), created Build America Bonds. The idea was simple: issue taxable municipal bonds, but provide the issuer with a federal subsidy equal to 35% of the coupon interest. This would allow municipalities to offer lower yields (because the subsidy reduced their borrowing cost) while still being attractive to investors who paid federal taxes on the interest.

Between April 2009 and December 2010, municipalities issued roughly $180 billion in BABs. The program was successful in reviving municipal financing and was politically popular because it supported infrastructure and job creation.

How Build America Bonds worked

A municipality issuing a BAB was required to pay a taxable coupon (not tax-exempt). If it issued a 5% coupon, the issuer paid 5% to bondholders. But the U.S. Treasury simultaneously paid the issuer a subsidy equal to 35% × 5% = 1.75%.

The issuer's net borrowing cost was 5% − 1.75% = 3.25%. This was substantially lower than the cost of traditional munis at the time (which might have been 4.5% or higher during the credit crisis).

The bondholder received 5% in taxable interest. If you were in the 37% federal tax bracket, your after-tax yield was 5% × (1 − 0.37) = 3.15%. This was attractive because:

1. It was higher than Treasury yields at the time (roughly 2–3%)
2. It was available to tax-exempt institutions (who had no tax benefit from traditional munis)
3. It provided credit diversification away from Treasuries

Comparing BABs to traditional munis

The BAB structure revealed the true value of tax exemption. By setting the federal subsidy at 35%, the government was essentially saying: "The tax exemption is worth about 35% of the coupon for the marginal investor."

If a traditional (tax-exempt) muni and a BAB of identical credit quality and maturity were issued simultaneously:

• Muni coupon: 4% (entirely tax-exempt, no federal subsidy)
• BAB coupon: 5% (fully taxable, plus 35% subsidy to issuer = 1.75%)
• BAB net cost to issuer: 5% − 1.75% = 3.25%
• Muni net cost to issuer: 4% (no subsidy)

The muni cost the issuer 4%, while the BAB cost 3.25%. Yet investors required higher nominal yields on BABs to compensate for the tax burden.

This demonstrated that the tax-exempt advantage to investors was substantial — they were willing to pay a premium (higher bond price, lower yield) for the exemption.

Who benefited from BABs?

Tax-exempt investors were the biggest winners:

• Pension funds (corporate and public) paid no federal income tax, so the tax exemption of traditional munis was worthless to them
• Universities and endowments (tax-exempt nonprofits) similarly benefited from higher yields on BABs
• Foreign investors (who did not owe federal U.S. income tax on most U.S. income) benefited from BAB yields with no tax burden

A pension fund could buy a BAB yielding 5% with no tax consequence, whereas a traditional muni might yield only 4%. The BAB was clearly better.

High-income taxable investors were less enthusiastic:

• A 37% bracket investor buying a 5% BAB earned 3.15% after-tax
• A 4% tax-exempt muni earned 4% after-tax
• The muni was superior despite the lower coupon

Middle-income investors found BABs mildly attractive:

• A 24% bracket investor on a 5% BAB earned 3.8% after-tax
• A 4% tax-exempt muni earned 4% after-tax
• The muni was still better, but the difference was smaller

The end of the program and fiscal concerns

Build America Bonds were tremendously popular, and municipalities issued substantial volume. But the federal subsidy came at a cost: roughly $9 billion per year in federal expenditures (the Treasury paying 35% of BAB interest).

In the context of the 2010 deficit debates and budget-cutting mood, the program was allowed to expire at the end of 2010. The subsidy was expensive, and critics argued it was an inefficient way to fund infrastructure (direct federal spending would be more transparent). The program ended, and no new BABs have been issued since.

However, some BABs remain outstanding. A 30-year BAB issued in 2009 with a 2039 maturity would still exist today. These outstanding BABs are less liquid than active-issue munis, but they trade in the secondary market.

Outstanding BABs today: characteristics and challenges

For an investor encountering an outstanding BAB in 2024:

Higher yields, but taxable:

• An outstanding BAB might yield 5.5% (because older coupon rates are higher than current rates, and these are now illiquid)
• You owe federal income tax on the full 5.5%
• At a 37% bracket, your after-tax yield is 5.5% × (1 − 0.37) = 3.47%

Limited liquidity:

• BABs are rarely actively traded today (the market has moved on)
• Bid-ask spreads can be wide (1% or more)
• Finding a buyer or seller may take days

Credit quality is variable:

• Some older BABs are from municipalities that have since faced credit stress
• You must evaluate each BAB on its own credit fundamentals
• Some high-yield BABs reflect credit concerns, not market opportunity

The federal subsidy is now uncertain:

• The original subsidy program ended in 2010
• Existing BAB holders do not receive the 35% federal subsidy (that was for the original issuer)
• Some BABs have included "Subsidy Bonds" language where the issuer agreed to make up any lost subsidy; this is a credit risk factor

Comparing BABs to current alternatives (2024)

A typical analysis today:

Outstanding BAB yielding 5.5%, maturing in 2034, A-rated:

• After-tax yield (37% bracket): 3.47%

Current taxable bonds with comparable credit and maturity:

• 10-year Treasury: 4.2%
• 10-year BBB corporate: 5.2%
• 10-year muni (A-rated): 3.8% (tax-exempt; TEY = 6.67% at 37% bracket)

Decision:

• The outstanding BAB (3.47% after-tax) is inferior to all three alternatives
• The muni (3.8% tax-exempt = 3.8% after-tax) beats the BAB by 33 basis points
• The BAB is the worst choice for a high-income investor

This is typical. Outstanding BABs are rarely attractive relative to current munis or taxable bonds, because the BAB's tax burden (unlike the tax exemption of munis) is no longer relevant to the issuer or taxpayers — it is just a legacy security trading on its credit and coupon relative to alternatives.

The broader lesson: tax exemption drives valuation

The existence of Build America Bonds and their relative underperformance to tax-exempt munis demonstrates how much tax exemption matters. The federal government had to offer:

1. Higher nominal yields (5% BAB vs. 4% muni)
2. A federal subsidy to the issuer (35% of the coupon)
3. Approval from Congress

...and even then, BABs appealed primarily to tax-exempt institutions (who had no reason to prefer tax exemption).

For taxable individuals, the conclusion was clear: tax exemption is worth roughly 80–150 basis points of yield, depending on your bracket. This is why munis exist as a distinct asset class and why high-income earners benefit from them.

Flowchart: BAB evaluation and comparison

Next

Build America Bonds were a fascinating experiment that revealed how tax exemption drives municipal finance. They were primarily used domestically in the United States, but municipal financing is global. In the next article, we'll explore how other countries (particularly the United Kingdom) handle municipal and local authority debt, and why there is no direct equivalent to U.S. municipal bonds abroad.

Related concepts

• Tax-Exempt Status Explained
• What Are Municipal Bonds?
• Tax-Equivalent Yield for Munis