The new bond in town

Lost in the ideological battles over fiscal stimulus is one newly authorized program that is already delivering results: Build America Bonds (BABs). Unexpected demand has transformed this once-obscure component of the federal stimulus legislation into the hottest bond since Daniel Craig.

California, the University of Minnesota, the New Jersey Turnpike Authority, and the New York Metropolitan Transportation Authority have been among the first to issue this new class of municipal bond, which could transform how America finances its 21st-century infrastructure needs.

California led the way with a $5.23 billion sale of BABs, a move that State Treasurer Bill Lockyer says will save the state $1.15 billion over the next 30 years.

Just weeks after the program began, sales have reached $10 billion. Market experts now predict that $50 billion in BABs could be sold this year, representing more than 10 percent of the annual municipal-debt issuance.

So how do BABs differ from conventional municipal bonds (munis)? The gist is that BABs alter the federal subsidy for state and local infrastructure investments to more efficiently tap private bond markets.

Conventional munis are subsidized through tax exemptions: Bondholders pay no income tax on interest payments received from the issuer. This setup offers no financial incentive for many categories of potential investors, such as pension funds and endowments, that already operate tax-free.

By contrast, BABs, which must be used for capital expenditures, are taxable bonds subsidized at 35 percent. This subsidy is available either as a tax credit to the bondholder or a direct cash payment to the local issuer. Taxable bonds offer investors a higher rate of return in exchange for relinquishing a portion of their interest income. That's why BABs offer investors more bang for their buck than conventional munis. And because the tax credit is paid to the issuer, purchasers of BABs need not be taxpayers, opening up a new market for state and local government debt.

Whereas municipal bonds are seen as a staid, small-bore asset class, BABs operate more like corporate bonds, with the security of semi-sovereign credit.

Their surging popularity is crowding out the supply of conventional munis, raising prices and lowering yields.

All told, with the new subsidy in place, state and local governments should find it cheaper and easier to access capital markets to finance their infrastructure priorities.

BABs look like a win-win-win for cash-strapped local governments, risk-averse investors, and beneficiaries of new infrastructure investment.

To be sure, the first issuers may have gotten a raw deal: BABs have proved so popular in secondary trading markets that their yields have fallen substantially, an indication that early investors underpaid.

We must therefore continue to monitor the program. Last fall's financial crisis and concerns about state budget solvency wreaked havoc on municipal bond markets.

They may be less visionary than a National Infrastructure Bank, and less hot-button than the direct spending that's also part of the stimulus, but BABs have gotten the money flowing again.

Daniel Mandel works at the New America Foundation.