What Was a Build America Bond?
Most municipal bonds are known for one particular feature: interest that’s typically exempt from federal income tax. Build America Bonds were a notable departure from that pattern, and understanding why helps explain how they still turn up in bond portfolios today.
The short answer
A Build America Bond, often shortened to BAB, was a type of taxable municipal bond that state and local governments could issue for a limited period, with the federal government providing a subsidy to help offset the higher borrowing cost of issuing taxable rather than tax-exempt debt. Unlike traditional municipal bonds, the interest on Build America Bonds was subject to federal income tax for the investor. The program was designed to widen the pool of investors willing to buy municipal debt by making it attractive to buyers who don’t benefit from tax-exempt income in the first place.
Why a taxable municipal bond made sense
Traditional municipal bonds appeal mainly to investors in higher tax brackets, since the value of tax-exempt interest depends on having taxable income to shelter. Investors who don’t need that tax break, such as certain retirement accounts or institutions, generally have less reason to accept a lower yield in exchange for tax exemption. By issuing taxable debt instead, state and local governments could market Build America Bonds to a much wider range of buyers, potentially lowering their overall borrowing cost despite paying a higher stated interest rate.
How the subsidy structure worked
To make taxable issuance worthwhile for the issuer, the federal government provided a subsidy tied to the bond’s interest payments, effectively offsetting part of the cost of paying a higher, taxable coupon. This let issuers access a broader investor base without simply absorbing a higher total borrowing cost on their own. The subsidy was the mechanism that made the whole arrangement work: without it, taxable municipal debt generally wouldn’t have been cost-competitive with traditional tax-exempt issuance for the borrower.
Why they still show up in bond holdings
Although the program that created new Build America Bonds ran only for a set period and has since ended, bonds issued during that window carry maturities that can extend many years into the future. That’s why BABs still appear in some bond fund holdings and portfolios today, even though no new ones are being issued. An investor looking at fund holdings might spot a Build America Bond alongside other corporate bonds and treasuries, since it behaves like an ordinary taxable bond from a credit and pricing standpoint despite its municipal origin.
What made this structure notable
The core idea behind Build America Bonds — trading tax exemption for a broader investor base plus a government subsidy — was a distinctive experiment in how municipal financing can be structured, not unlike how a supranational bond represents its own experiment in broadening who can back a bond issuance. It illustrates that “municipal bond” and “tax-exempt bond” aren’t automatically the same thing, and that the tax treatment of a bond’s interest is a separate question from who issued it.
A practical habit
When evaluating any bond described as municipal, it’s worth checking whether its interest is actually tax-exempt rather than assuming so by default, since taxable municipal debt like Build America Bonds shows that the two labels don’t always travel together. That habit of checking the specific tax treatment, rather than relying on the issuer type alone, applies just as well to bonds issued today as it did to this now-closed program.