Build America Bonds

A Build America Bond (or BAB) was a taxable municipal bond created under the 2009 American Recovery and Reinvestment Act, where the federal government reimbursed issuers or buyers for a portion of the interest cost. The subsidy—typically 35% of the coupon—made borrowing cheaper for states and localities while creating a new asset class that appealed to tax-indifferent investors like pension funds.

Why the federal government created them

During the Great Recession and financial crisis of 2008–2009, state and local government revenue collapsed. Tax revenue from income and sales taxes plummeted as employment and consumption fell. At the same time, capital-project pipelines—highways, schools, water systems—faced delays because borrowing costs spiked. Traditional municipal bonds, which relied on federal tax-exemption to attract buyers, became harder to place.

Washington’s solution was the Build America Bond program. Rather than expand the federal government’s own spending directly, lawmakers created a subsidy that lowered the cost of municipal borrowing. This preserved local investment capacity while keeping the fiscal stimulus indirect.

The mechanism was elegant: municipalities and other public entities could issue taxable bonds and receive a direct federal payment equal to 35% of the coupon (or 55% for certain issuer types, such as issuers in economically distressed areas). Because the interest was taxable, the bonds no longer relied on tax-exemption to appeal to investors. This opened them to a broader pool of buyers—pension funds, insurance companies, foreign investors—who had no use for tax-exempt status.

How they worked in practice

A municipality would issue a BAB with a 5% coupon. Investors would receive the full 5% annually, and pay tax on it like ordinary income. The federal government, separately, would rebate the issuer (or sometimes pay the bondholder directly) 35% of 5%—that is, 1.75 per year. The issuer’s effective borrowing cost fell to approximately 3.25%.

This structure created several advantages:

For issuers: The subsidy lowered the true cost of capital for infrastructure projects. Even though the nominal coupon was higher (and taxable), the net cost after federal reimbursement was lower than the issuer could have achieved with traditional tax-exempt bonds, especially in a high-rate environment.

For investors: A pension fund or insurance company could hold a higher-yielding taxable bond without giving up any benefit—since they rarely benefited from tax-exemption anyway. A non-US investor could buy a US municipal bond yielding 4–5%, something nearly impossible before BABs existed.

For the federal government: In theory, the stimulus cost was known and contained. If Congress appropriated funds for BAB rebates, the liability was measurable.

The tax-credit variant

A related program, also part of the 2009 act, issued tax-credit bonds, which paid a lower coupon but gave bondholders a federal tax credit. These were less popular than direct-pay BABs because the timing of the tax benefit often didn’t match the investor’s tax situation.

Why they expired and what happened next

The BAB program was always intended to be temporary, ending on 31 December 2010. By then, credit markets had stabilized and equity markets had begun their long recovery. The initial rationale—a credit crisis starving municipalities of capital—had faded.

What followed was politically awkward. Many issuers and investors wanted the program extended. Some states and localities had structured multi-year infrastructure plans around BAB financing. But the federal government had a budget-deficit problem, and extending the subsidy was expensive in official scoring, even though the net cost to the taxpayer was arguable.

Congress allowed the program to sunset. A few small extensions and modifications were enacted years later, and a small carve-out for certain issuers persisted, but the broad, open BAB program never returned.

Legacy and lessons

Build America Bonds taught several lessons that shape municipal-finance policy today:

Subsidies can work. By lowering the after-cost borrowing rate, BABs demonstrably stimulated near-term municipal borrowing and project spending when the economy needed it. Unlike a direct federal spending program, it distributed the stimulus through the credit market.

Tax-exemption has limits. The fact that pension funds and foreign investors were willing to pay for BABs revealed that traditional tax-exempt municipal bonds are, in effect, a hidden subsidy to wealthy taxpayers in high tax-bracket brackets. Direct federal subsidies, by contrast, can be targeted and transparent.

Political uncertainty kills programs. Knowing the program would end in two years may have discouraged some issuers from financing long-term projects. If the program had been permanent, cities might have planned differently.

Today, advocates periodically propose restarting or modernizing BABs, especially during economic downturns. The fundamental idea—using federal subsidies rather than tax-exemption to lower municipal borrowing costs—remains sound. But politics, fiscal constraints, and competing priorities have kept BABs in history rather than active use.

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