Low-Cost Exposure To Taxable Municipal Bonds

| About: PowerShares Build (BAB)
This article is now exclusive for PRO subscribers.

By Thomas Boccellari

The recent credit troubles in Detroit and Puerto Rico should not scare investors away from the municipal bond market. Many of these securities offer similar--or better--yields than corporate bonds, with comparable credit risk. However, they do tend to carry greater interest-rate risk. PowerShares Build America Bond ETF (NYSEARCA:BAB) may be an ideal offering for investors who can accept this risk.

This exchange-traded fund offers diversified market-cap-weighted exposure to U.S. dollar-denominated Build America Bonds issued by U.S. state and territory municipalities. Build America Bonds are taxable municipal bonds that were issued as part of the American Recovery and Reinvestment Act of 2009. Although these bonds are not tax-exempt at the federal level, they may be tax-exempt at the state level for investors residing in the jurisdiction of the issuer. When these bonds were first issued, the federal government subsidized 35% of the issuers' interest cost. However, the government has since reduced this subsidy to 27.7% of the issuers' interest expenses because of sequestration.

Municipalities stopped issuing new Build America Bonds after funding for the program dried up in 2011. Because the secondary market is relatively thin, portfolio turnover is low. If interest rates rise, the fund will be unable to buy new issuances with higher interest rates to offset principal losses from current holdings.

The fund's current yield-to-maturity (4.7%) is higher than the average traditional long-term bond ETF (4.2%). However, the fund's yield is less than the tax-equivalent yield of tax-exempt municipal bond funds (7.7%). This could limit its usefulness in a taxable account relative to traditional municipal bond funds. However, it may be a suitable satellite holding for investors who want exposure to taxable U.S. municipals with a long duration.

Build America Bonds were issued between 2009 and 2010 after the traditional tax-exempt municipal bond market froze during the financial crisis, to help municipal issuers raise capital to fund public projects. During the life of the program, more than $180 billion in Build America Bonds were issued. Although Build America Bonds are no longer issued, the fund's asset base of $680 million should allow the fund the ability to grow to meet investor demand going forward using the secondary market.

Because of the lack of new bond issuances, the fund's duration should decline over time, until bonds in the portfolio begin to mature. The portfolio's average maturity is 19.8 years, and its duration is 8.8 years.

The fund weights its holdings by market capitalization, which means that the most heavily indebted issuers receive the largest weightings in the portfolio. This weighting approach could increase credit risk because issuers with the heaviest debt burdens, like California and Illinois, may be the most susceptible to ratings downgrades. However, the fund's focus on investment-grade bonds helps mitigate credit risk.

In California, the largest issuer represented in the fund's portfolio, the unemployment rate reached a high of 12.0% in 2008. High unemployment led to reduced tax revenue and increased the state's debt burden. This created fear in the municipal bond market that California would have a tough time raising tax revenue to meet increased interest payments.

Over the past two years, however, heavily indebted states like Illinois and California have slowed the amount of debt they issued and boosted tax revenue. At the same time, unemployment in these states has declined toward the national average. This has helped stabilize the municipal bond market in these heavily indebted states because they are now better able to pay their interest obligations.

Going forward, however, many states may face an uphill battle. A recent report by the Nelson Rockefeller Institute of Government shows that, after three years of improving fundamentals, 2014 may be a tough year for state governments. The Institute estimates that tax revenue will likely decline in 42 states, including California and Illinois, where it estimates tax revenue will fall by 11.9% and 10.3%, respectively.

In 2013, the federal government cut the Build America Bond subsidy to 26.3% from 35%. For 2014, the subsidy is 27.7%. Cuts are expected to remain in effect through 2024. Although this has not had a significant impact on the Build America Bonds, further sequestration could negatively affect this segment and could negate the benefit of using Build America Bonds over traditional tax-exempt municipal bonds.

California currently has an average credit rating of A, while Illinois has an average credit rating of A-. Texas, the third-largest issuer represented in the fund's portfolio, has an average credit rating of AAA.

Portfolio Construction
The fund employs representative sampling to track the Bank of America Merrill Lynch Build America Bond Index, which measures the U.S. dollar-denominated Build America Bonds publicly issued by U.S. states and territories of varying maturities. The index weights its holdings by market cap and rebalances at the end of each month. California (22.1%), Illinois (12.4%), and Texas (10.1%) are the three largest issuers in the fund's portfolio. The bonds are issued by state and local governments and finance a variety of projects like transportation, education, and utilities.

The fund has an expense ratio of 0.28%, which is the lowest among Build America Bond ETFs. But it is above average compared with the long-term bond Morningstar Category average (0.26%). The fund has done a good job tracking its benchmark. Since its inception, it has outperformed its bogy by 0.01% a year.

SPDR Nuveen Barclays Build America Bond (NYSEARCA:BABS) is the second-largest Build America Bond ETF. BABS, however, only has $75 million in assets and is thinly traded. Further, it has a higher fee (0.35%) and a longer duration (12.5 years).

BlackRock Build America Bond (NYSE:BBN)--a closed-end fund--may also be an interesting alternative. It has a total expense ratio of 1.10% and a leverage-adjusted duration of 13.4 years.

Vanguard Long-Term Bond (NYSEARCA:BLV) is the largest and cheapest long-term bond ETF. It has a rock-bottom 0.10% fee and a duration of 14.2 years.

Disclosure: Morningstar, Inc. licenses its indexes to institutions for a variety of reasons, including the creation of investment products and the benchmarking of existing products. When licensing indexes for the creation or benchmarking of investment products, Morningstar receives fees that are mainly based on fund assets under management. As of Sept. 30, 2012, AlphaPro Management, BlackRock Asset Management, First Asset, First Trust, Invesco, Merrill Lynch, Northern Trust, Nuveen, and Van Eck license one or more Morningstar indexes for this purpose. These investment products are not sponsored, issued, marketed, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in any investment product based on or benchmarked against a Morningstar index.