Build America and Boost Yields

09/27/2010 10:54 am EST

Focus: ETFS

Paul Justice

Associate Director of North American ETF Research, Morningstar, Inc.

Paul Justice, director of North American ETF Research for Morningstar, and analyst Timothy Strauts say a new ETF gives investors exposure to popular Build America bonds, but has risks.

Build America bonds are a new type of taxable fixed income created in the last 18 months. They have been tremendously successful, because they offer higher yields than comparable corporate bonds, and because they are municipal debt their credit quality is strong.

In this low-interest-rate environment, an investment with a yield above 5% is quite attractive. While interest rates are expected to stay low for the next six to 12 months, PowerShares Build America Bond’s (NYSEArca: BAB) average maturity of 22 years creates tremendous interest-rate risk. Investors need to be aware of this new asset class because it is changing the dynamics of the taxable and tax-free fixed-income space.

This fund is a satellite fixed-income holding for an investor looking for taxable municipal bonds with a long duration. Investors holding this fund are looking for a relatively safe and consistent income stream. BAB is highly exposed to interest-rate and inflation risk because of its long duration (a measure of its sensitivity to changes in interest rates—Editor).

That is, if there is a rise in inflation or the real rate of return demanded by the market, the price on this fund will drop until the yield is high enough to reflect the current market sentiment. Conversely, if interest rates go lower because of deflation, the value of this fund should rise.

Build America Bonds were first issued in April 2009 as part of the American Recovery and Reinvestment Act of 2009. They are taxable municipal bonds where the issuer receives from the federal government a cash subsidy equal to 35% of the interest payments. The program was created to help state and local governments that were having trouble receiving financing at the depth of the financial crisis.

Build America Bonds currently trade with higher interest rates than comparable corporate bonds because of the uncertainty surrounding them. If the program ends this year, the liquidity of existing Build America Bonds may decrease, and the viability of BAB will be in question.

BAB currently holds more than 270 bonds. The maturity of 87% of its bonds is greater than 15 years. Overall, the fund has a duration of around 11 years, and the average credit quality is AA. This fund charges a management fee of 0.28%. The interest payouts on all of its holdings are federally taxable.

We think municipal bonds still have a place in a portfolio. The credit issues of municipals are not an impending panic that will hit the market all at once, like the Greek sovereign-debt crisis. It is likely that municipal default rates will rise in the next few years, but they should stay below corporate default rates.

Owning a diversified fund such as BAB will help smooth out any issues that an individual issuer might run into.

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