The American Recovery and Reinvestment Act (ARRA), otherwise known as the stimulus package that was lambasted by critics who consider it wasteful government spending, actually appears to be succeeding in promoting utility construction projects. This success is presumably the first steps toward putting people back to work. There exists a small degree of recovery in the utility construction industry thanks in part to a new type of municipal bond that the stimulus package created — Build America Bonds.

Explanation of Build America Bonds

A Build America Bond (BAB) provides much-needed funding for state and local governments at lower borrowing costs, thus allowing for the construction of necessary capital projects, including public buildings, courthouses, schools, roads, transportation infrastructure, government hospitals, public safety facilities, water and sewer projects, environmental projects, energy projects, governmental housing projects and public utilities. Typically, state and municipal governments depend on tax-exempt bonds for capital to put towards the public works projects, but the recession has rendered a precipitous decline in the number of tax-exempt bonds being purchased. Thus, the drafters of the stimulus package devised BABs in order to raise capital with which state and local governments can fund capital projects.

BABs, which allow for a new direct federal payment subsidy, are taxable bonds issued by state and local governments that provide access to the conventional corporate debt markets. At the discretion of the state and local governments that issue the bonds, the Department of Treasury will make a direct payment to the state or local governmental issuer in an amount equal to 35 percent of the interest payment on the bond. This subsidy will result in a lower net borrowing cost for these government issuers and allow them to reach more sources of borrowing than with more traditional tax-exempt or tax credit bonds.

Healthy Demand for Build America Bonds

BABs are proving a good alternative to traditional tax-exempt bonds because they appeal to a larger market that typically invests in government bonds, the interest rates are usually 20 percent lower than tax-exempt bonds, and BABs increasingly make up a growing percentage of municipal bonds issued by state and local governments. The growing investor demand surrounding BABs continues to drive down the rate of interest payments; in addition, Department of the Treasury analysts have discovered that BABs provide issuers with significant savings at all maturity levels on the yield curve, especially at the long-term end of the curve. BABs differ from traditional municipal bonds by being target efficient, meaning that each dollar of revenue foregone by the federal government benefits state and local governments by a dollar.

Unlike ordinary, tax-exempt municipal bonds, the income generated by BABs is taxable. There exist two types of BABs. In the first version, the bond issuer receives a subsidy from the federal government equal to 35 percent of the interest paid to investors for purchasing the bonds; this subsidy permits government entities to issue bonds that pay interest rates competitive with rates paid by corporations. In the second version, BAB holders receive a tax credit from the federal government equal to 35 percent of the interest on the bond each year; the tax credit carries over to future years if the bondholder’s tax liability is not enough to cover the entire credit. The first version has proven more popular, especially for entities that do not pay U.S. income taxes such as pension plans and foreign investors.

Since the inception of the stimulus package and the subsequent inaugural issuance of BABs on April 15, 2009, state and local governments have issued over $106 billion in BABs, thus allowing them to employ thousands of workers and invest in new projects to improve infrastructure. The Department of the Treasury estimates that these bonds have saved state and municipal governments, institutions of higher learning and school districts over $12.3 billion collectively, which surpasses the overall cost to the federal government to implement and pay the 35 percent of the interest on these bonds. In the stimulus package, the drafters set aside nearly $28.2 billion to use toward paying the subsidies on BABs. At the current rate, if these bonds continue to save local and state governments money in financing infrastructure projects, then the estimated total savings from the BAB program will be considerable.

In the first 12 months of the program, 1,306 BABs were issued by local and state governments in 49 states, the District of Columbia and two territories. The Department of Treasury estimates approximately $16.4 billion in BABs have been issued so far to finance water, wastewater and other utility construction projects, and that total does not include BABs issued by states and municipalities for general infrastructure projects, some of which are water and wastewater projects. Initially, these bonds proved difficult to obtain because they were predominantly purchased by large institutional investors. When first offered, they were purchased so quickly that the ability of private investors to purchase them was effectively inhibited. Because BABs now constitute nearly 20 percent of the bond market, these problems have since been resolved.

Future of the BAB Program

Last month, the House of Representatives passed legislation that would extend the BAB program for two years while gradually reducing the subsidy payments the federal government makes to BAB issuers. For instance, in 2011 the federal government would pay 32 percent of the interest rate and only 28 percent in 2012. In addition, the American Jobs and Closing Tax Loopholes Act (H.R.4213) — also known as the Tax Extenders bill — if passed, would extend the BAB program for even longer, but President Obama is seeking to make BABs permanent with a 28 percent subsidy rate.

BABs represent are a prudent long-term investment because their average maturity is around 14 years as opposed to only nine years for traditional government bonds, but they pay significant dividends at all maturity levels. The Obama administration’s proposal to expand BABs and make the program permanent with a 28 percent subsidy rate that is revenue neutral for the federal government would provide greater certainty in municipal financing, likely leading to lower underwriting fees, enhanced retail ownership of BABs and continued savings on borrowing costs for state and local governments. Given the popularity of BABs, should the program live on after the stimulus, it may become an important source of funding for water and wastewater infrastructure projects.

Evan Gold is a NUCA Government Relations Intern.