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When President Obama signed into law the American Recovery and Reinvestment Act of 2009, the nation was sharply divided on the bill. Designed to create jobs and promote investment during one of the worst recessions to ever hit the U.S. economy, “the Stimulus” called for measures worth a total of $787, including tax incentives, expansion of unemployment benefits, and spending in health care, education, and infrastructure.

Nearly two years later, the Federal Reserve has commenced another round of quantitative easing, an admission that AARA has so far been unsuccessful in accomplishing some of its most aggressive objectives and that significant obstacles remain ahead for the U.S. economy. But to call the plan as a whole a failure would overlook many of the components that have proven productive. One of AARA’s bright spots has been the Build America Bond program, an initiative that allows state and local governments to issue taxable debt to finance construction projects at reduced borrowing costs.

Unlike traditional municipal bonds, BABs are taxable securities. The Treasury Department reimburses issuers for 35% of interest payments, allowing municipalities to tap into more liquid taxable debt markets without a big increase in borrowing costs. Since the stimulus bill was approved in February 2009, more than $150 billion in Build America Bonds have been issued, including securities used to fund several high profile infrastructure projects. The new bridge across the San Francisco Bay and mass transit system in New Jersey are just two of the initiatives financed with Build America Bonds.

Build America Bond ETFs

Build America Bonds have also given a boost to several ETF issuers, as investors have embraced exchange-traded products as an efficient means of accessing this corner of the fixed income market. Currently, there are several ETFs focusing exclusively on Build America Bonds:

  • PowerShares Build America Bond Portfolio (NYSEARCA:BAB): This ETF seeks to replicate the BofA Merrill Lynch Build America Index, a broad-based BABs benchmark. Given the recent inception of BABs, it isn’t surprising that this fund is positioned towards the long end of the duration spectrum; only about 1% of holdings are expected to mature in the next five years (PowerShares has filed for an ETF that would focus on shorter duration Build America Bonds). BAB has taken in more than $500 million in assets and charges an expense ratio of 35 basis points.
  • PIMCO Build America Bond Strategy Fund (NYSEARCA:BABZ): This actively-managed ETF is a relatively new addition to the ETF lineup, having launched in September of 2010. Similar to BAB, the PIMCO fund is also heavy in long-dated securities; the effective duration recently stood at about 13 years. BABZ charges 0.45% in expenses, making it comparable to passive BABs ETFs from a cost perspective.
  • SPDR Nuveen Barclays Capital Build America Bond ETF (NYSEARCA:BABS): This ETF seeks to replicate the Barclays Capital Build America Bond Index, and also maintains an effective duration of close to 13 years. BABS makes significant allocations to BABs from California issuers (35% of assets), with New York (15%) and Texas (14%) also receiving big weightings. BABS charges an expense ratio of 0.35%.

Uncertain Future

Earlier in the year, it was widely anticipated that lawmakers would once again extend the Build America Bond program, which is currently scheduled to expire at the end of 2010. But after a landslide Republican victory in mid-term elections gave the GOP control of the House of Representatives, the program faces a very uncertain future. Supporters of the program have called for the lame duck session of Congress that convened this week to push through the extension now, noting that the odds will become considerably longer once recently-elected representatives and senators take office in January.

On Tuesday, an aide to Senate Finance Committee Chairman Max Baucus indicated that the BABs program would be included in an “extenders” bill currently being crafted. The aide said:

Chairman Baucus is fighting to pass legislation to extend vital individual, family and business tax cuts – including the Build America Bonds program through 2011.

Still, there is no certainty that the program will last into 2011, and the terms of any possible extension are seemingly still in flux.

Opponents of an extension for the Build America Bond program argue that the subsidies should be reeled in and could perhaps be put to better use elsewhere. David Reilly writes:

The best course would be for legislators to end what is essentially just another bailout. State and local governments need incentives to get their financial houses in order, as painful as that might be. By subsidizing the cost of borrowing with this program, the federal government reduces the incentive to do so.

According to the Congressional Budget Office, the program was expected to cost $36 billion in the ten years following its creation. But some have argued that the actual cost will be much higher due to the holding of BABs by tax deferred or tax exempt investors–reducing government collections stemming from the projects. Others have argued that local governments don’t create the types of jobs that foster economic recovery.

Impact on ETFs

So what does all the uncertainty surrounding a potential extension mean for Build America Bond ETFs? Not as much as some might have you believe. If the program gets axed altogether in coming weeks, the Build America Bond market won’t disappear overnight. Many of the BABs already issued are long-term bonds; about 85% of the holdings of BAB have maturities of at least 15 years, and more than 35% don’t mature for at least 25 years. If an extension isn’t passed, the pool of Build America Bonds would slowly dwindle over the next 30 years. But it is unlikely that a suspension of new creations would have much of an impact on demand for securities that have already been issued.

If anything, a failure to come up with an extension could ultimately give a boost to securities issued under the Build America Bond program; scarcity has a tendency to push prices higher. Likewise, if the program is extended with a 28% subsidy – as the Obama administration has proposed in its fiscal year 2011 budget proposal – the juicier yields offered by the “first generation” of BABs could become more appealing to fixed income investors.

If it appears that December 31 will mark the end of the road for this portion of the stimulus plan, the final few weeks of the year could be chaotic for BABs. Eligible issuers may make efforts to squeeze in new issuances before the window closes (or subsidy is slashed), potentially flooding what some believe is an already saturated municipal bond market with even more debt.

Disclosure: No positions

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Source: Uncertain Future for Build America Bond ETFs