Build America Bonds: History and Lessons
Build America Bonds represented the most significant innovation in municipal finance in decades. Between April 2009 and December 2010, state and local governments issued over $181 billion in BABs—accounting for 21.6% of total municipal issuance during the program's brief window (Treasury Department, 2010). The point is: BABs proved that taxable municipal bonds could attract entirely new investor classes while saving issuers billions in borrowing costs (Cestau & Green, 2018).
What Build America Bonds Were (The Mechanics)
BABs were taxable municipal bonds with a federal subsidy. Unlike traditional tax-exempt munis—where investors avoid paying federal income tax on interest—BABs paid fully taxable interest. The innovation was how issuers got compensated.
Two BAB structures:
- Direct Payment BABs: The federal government paid 35% of interest costs directly to the issuer. If a state paid $10 million in annual interest, the Treasury sent a $3.5 million check. Over 88% of BABs used this structure.
- Tax Credit BABs: Investors received a tax credit equal to 35% of interest. Complexity made these less popular.
Why the subsidy mattered: Traditional tax-exempt bonds attract primarily U.S. taxable investors—individuals, insurance companies, and banks. BABs attracted pension funds, foreign investors, and others who gain nothing from tax exemption but happily buy taxable bonds.
The durable lesson: Widening the investor base lowered borrowing costs more than tax exemption alone.
The Economic Context (Why 2009 Required Innovation)
The 2008-2009 financial crisis devastated municipal finance. Credit markets froze. Auction-rate securities failed. Bond insurance companies lost their AAA ratings.
The municipal market in crisis:
- Traditional buyers pulled back amid economic uncertainty
- Insurance company losses reduced capacity to buy munis
- Pension funds and foreign investors remained sidelined (no benefit from tax exemption)
The American Recovery and Reinvestment Act (ARRA) of February 2009 created BABs specifically to:
- Provide fiscal stimulus through infrastructure spending
- Lower borrowing costs for struggling governments
- Attract new capital into municipal markets
The program launched April 3, 2009 and ran through December 31, 2010—just 21 months.
The Numbers: What BABs Achieved
The program's scale exceeded expectations. 929 separate BAB issues across 47 states demonstrated broad geographic adoption (SIFMA, 2011).
Issuance by use of proceeds:
- Education: 30%
- Water and sewer: 14%
- Roads and bridges: 14%
- Transit: 9%
- Other: 33%
2009 alone saw $63.4 billion in BAB issuance—remarkable given the program only launched in April. The momentum continued into 2010.
Interest cost savings:
The Treasury estimated $12 billion in interest savings during 2009 alone, with lifetime savings exceeding $20 billion (Treasury Department, 2010). Research confirms BABs priced 25-40 basis points tighter than equivalent traditional tax-exempt issues would have (Ang & Longstaff, 2013).
Why BABs Attracted New Investors (The Demand Story)
Tax-exempt municipal bonds appeal to a narrow audience—primarily U.S. taxpayers in high brackets. BABs opened municipal credit to the global fixed income universe.
New buyer categories:
- Pension funds: Need income, not tax breaks. BABs offered higher yields than Treasuries with municipal credit quality.
- Foreign investors: Cannot use U.S. tax exemptions. BABs provided access to state and local government credit.
- Insurance companies: Some preferred taxable income for asset-liability matching.
- Mutual funds: Taxable bond funds could now own municipal credit.
The investor base shift:
Traditional muni ownership is ~70% individual investors (directly or through funds). BAB ownership tilted heavily institutional—pension funds and foreign buyers represented significant portions of demand.
Why this worked: More bidders competing for bonds drives prices higher (yields lower). The subsidy made municipal credit accessible to buyers previously excluded.
The test: Wider investor base → More competition → Lower borrowing costs
Lessons for Infrastructure Finance (What Worked)
BABs demonstrated several principles now relevant to infrastructure funding debates:
Lesson 1: Subsidy Design Matters
Direct payment subsidies (where Treasury pays the issuer) worked better than tax credits (where investors claim credits). Simplicity attracted participation.
Lesson 2: Scale Attracts Institutional Capital
Large, liquid BAB issues attracted institutional buyers seeking significant positions. A $500 million California BAB issue could absorb pension fund demand that $10 million traditional issues could not.
Lesson 3: Taxable Structure Enables Refinancing Flexibility
Traditional tax-exempt bonds face restrictions on advance refunding. BABs, being taxable, avoided these limitations—providing issuers more flexibility to refinance when rates declined.
Lesson 4: Federal Support Can Jumpstart Markets
The federal subsidy demonstrated that Washington can catalyze municipal investment without nationalizing infrastructure. The private sector funded projects; federal support reduced costs.
Why BABs Ended (The Political Reality)
Congress did not extend the BAB program beyond December 31, 2010. Several factors contributed:
Political opposition: Some viewed BABs as federal spending rather than tax expenditure—changing the accounting optics even though the economic effect was similar to tax exemption.
Deficit concerns: The direct payment subsidy appeared on the federal budget as spending. Tax exemption (a "tax expenditure") doesn't appear in spending figures.
Sequestration impact: After the program ended, existing BAB holders faced an unexpected hit. The 2013 sequester cut BAB subsidy payments by 8.7%, effectively raising borrowing costs retroactively for issuers who had already sold bonds.
The 2013 sequester reduced BAB payments from 35% to approximately 32%—violating the implicit promise to issuers who structured financing around the original subsidy (GAO, 2015).
What Happened to Outstanding BABs?
Over $181 billion in BABs remain outstanding (declining as bonds mature or are refunded). These securities continue trading in taxable bond markets.
Investor experience:
BAB holders received taxable interest at rates above comparable Treasuries—reflecting municipal credit spreads. For institutional investors unable to use tax exemption, BABs provided attractive risk-adjusted returns.
Issuer experience:
Issuers saved billions in interest costs during issuance. However, sequestration cuts meant realized savings fell short of original projections for some issuers.
Revival Proposals (Why BABs Keep Coming Back)
Since 2010, multiple legislative proposals have sought to revive or modify the BAB structure:
Why proponents push for revival:
- Infrastructure needs remain enormous (American Society of Civil Engineers estimates $2.6 trillion gap)
- Climate adaptation projects require massive investment
- Traditional tax exemption limits the investor base
Why revival hasn't happened:
- Federal budget scoring treats subsidies as "spending"
- Tax exemption defenders protect existing structure
- Political will for large infrastructure programs fluctuates
The recurring debate: Should federal support for municipal borrowing come through tax exemption (invisible budget impact) or direct subsidy (visible spending)? The economic effect is similar; the political optics differ dramatically.
What BABs Teach About Municipal Markets
The BAB experiment confirmed several market dynamics (Ang & Longstaff, 2013):
Tax clientele effects are real: Traditional munis trade at yields reflecting the marginal tax bracket of high-income buyers. BABs traded based on institutional credit analysis—different pricing dynamics entirely.
Liquidity improved: Large, standardized BAB issues traded more actively than fragmented traditional muni issuance. The corporate bond market structure (institutional, liquid) proved compatible with municipal credit.
Municipal credit stands on its own: Stripped of tax exemption, municipal credit still attracted buyers at competitive spreads. The underlying credit quality—not just tax benefits—has value.
Checklist: Understanding BAB-Style Proposals
Essential (Know This)
- BABs substituted a 35% federal subsidy for traditional tax exemption
- Over $181 billion issued from April 2009 to December 2010
- Direct payment structure worked better than tax credit structure
- Program ended due to political—not economic—factors
High-Impact Context
- Sequestration cut existing BAB subsidies post-issuance (8.7% reduction)
- Revival proposals surface regularly but face budget-scoring hurdles
- BAB model could apply to future infrastructure, climate, or housing finance
Your Next Step
If you hold municipal bond funds, check whether they contain any remaining BABs. These taxable securities trade based on credit quality rather than tax effects—and may behave differently than tax-exempt holdings during rate changes. Understanding the difference prepares you for future infrastructure financing innovations.
Related: Infrastructure Financing via Municipal Bonds | Tax-Equivalent Yield Calculations | General Obligation vs. Revenue Bonds
Sources: Ang, A. & Longstaff, F. (2013). Systemic Sovereign Credit Risk: Lessons from the U.S. and Europe. Journal of Monetary Economics. | Cestau, D. & Green, R. (2018). Tax Incentives and the Demand for Municipal Bonds. Review of Financial Studies. | Treasury Department (2010). Build America Bonds Program Summary. | GAO (2015). Sequestration and Federal Programs.