What are Build America Bonds or direct-pay municipal bonds?

Interest on many municipal bonds issued by local and state governments and some non-profits is exempt from federal income taxes. As a result, investors, mainly high-income individuals, are willing to lend money to issuers at a lower interest rate than they would demand if the bonds were taxable. Build America Bonds (known as BABs or direct-pay bonds) were created by the American Recovery and Reinvestment Act of 2009 as an alternative way for the federal government to subsidize local and state government borrowing. Instead of making the interest on those bonds exempt from federal income taxes, the federal government provided a subsidy directly.

The BABs program ended in 2010, but the concept has been part of the 2021 debate over financing increased federal infrastructure spending. Here is a primer on these bonds.

How did BABs work?

Because the interest investors earn on municipal bonds is generally exempt from federal income taxes, an investor in the top income tax bracket can earn the same after-tax return on a lower-yielding municipal bond as on a higher-yielding taxable bond. For example, for an investor in the top tax bracket, the after-tax return on a 1.3% tax-exempt bond is the same as on a 2.15% taxable bond.

With BABs, the interest was taxable to investors, but the federal government gave state and local governments the choice of a direct subsidy to cover 35% of the interest costs (Direct Payment bonds) or to offer bondholders a federal tax credit worth 35% of the interest earned (Tax Credit bonds). Direct Payment bonds accounted for over 88% of BABs issued across 2009 and 2010.

Between April 2009 and December 2010, over $181 billion in BABs were issued, accounting for 21.6% of the total debt issued in municipal bonds over the period. About 30% of the money state and local governments raised in BABs went to educational facilities, 14% went to water projects, 14% to roads and bridges, and 9% to transit.

What could state and local governments use BABs for?

State and local governments could issue Tax Credit BABs to pay off past debts or to fund the construction of new infrastructure (known as “capital projects”).

The more widely used Direct Payment bonds, in contrast, could only be used for new construction. State and local governments could use the proceeds to finance capital projects in public housing, public education, transportation facilities, water and sewer services, public utilities, etc.

What are the advantages of BABs over traditional tax-exempt municipal bonds?

Tax-exempt bonds generally appeal only to investors in high income-tax brackets. The BAB program broadened the municipal bond market to a wider range of buyers, including those who don’t pay federal income taxes at the top marginal rate, pension funds, endowments, and foreigners. This was particularly important in the immediate aftermath of the Global Financial Crisis, when many state and local governments had difficulty borrowing in the traditional municipal bond market, leading some of them to put infrastructure and other capital projects on hold. With more potential buyers of municipal debt, the interest rate that issuers had to pay was lower.

How well did BABs work?

Some research has found that BABs were very effective. For example, comparing yields on tax-exempt and BAB bonds by the same issuers, the U.S. Treasury estimated that BABs saved state and local governments more than $20 billion in interest spending over the long-term. An analysis by economists Gao Liu of Florida Atlantic University and Dwight Denison of the University of Kentucky, similar to the analysis done by the Treasury, found that BABs saved issuers 65 basis points on a typical bond compared to a traditional tax-exempt bond issue.

But Martin Luby of the University of Texas at Austin (and an advisor to state and local governments), Peter Orr of Intuitive Analytics, and Richard Ryffel of Washington University in St. Louis argue that that estimate is too big because it doesn’t account for the fact that the debt issued using BABs was more difficult for issuers to refinance than conventional tax-exempt bonds.

BABs were issued with “make-whole call provisions”—stipulations saying that if the issuer wanted to pay the remaining debt before maturity, they would have to pay investors the total interest the bond would have earned over its term. This made BABs much more expensive to pay off early so issuers were unable to take advantage of lower interest rates if rates fell over time.

Luby and co-authors estimate that, after accounting for the call option and subsequent refinancing, the savings were 35 basis points on BABs versus a traditional tax-exempt bond issue—much lower than other estimates. If BABs are to be reinstated in the future, “federal policymakers likely need to be more aggressive than previously thought in terms of setting a subsidy rate that will induce state and local governments to issue [them],” the authors conclude.

How did sequestration (across the board spending cuts) affect the BABs of 2009 and 2010?

A major problem with BABs was their vulnerability to sequesters, or across the board spending cuts. In 2012, Congress failed to meet the deficit targets it set in the Budget Control Act of 2011, triggering a sequester that reduced the amount of subsidy the federal government paid to BAB issuers starting in 2013. The federal subsidy payment, originally valued at 35% of the bond’s interest rate, was cut by 8.7% in the first year and by a smaller percentage in subsequent years.

This proved to be quite costly for issuers, who had to pay what they had promised to investors without the expected reimbursement from the federal government. The Metropolitan Water District of Southern California, for example, had to pay $1.98 million more over the life of a $250 million issue than had been anticipated before the sequester. In all, the sequester caused state and local governments to lose an estimated $2 billion in BAB subsidy payments over the 2013 to 2020 period, according to some estimates.

Some state and local governments were also concerned that the U.S. Treasury could withhold BAB subsidies if they owed money to the federal government (e.g., through programs like Medicaid). Florida stopped issuing BABs in May 2010, citing uncertainty that the federal government would follow through on the subsidy payments.

What is being considered now?

Proponents of the BAB program have advocated for its return since the program ended in 2010. President Obama unsuccessfully proposed to renew the program. In 2015, our colleagues at the Hamilton Project published a discussion paper, “Financing U.S. Transportation Infrastructure in the 21^st Century,” by Roger C. Altman (a former deputy Treasury secretary), Aaron Klein of Brookings, and Alan Krueger (who had been the top Treasury economist in the Obama administration), which said reinstating the program is crucial “to address the lack of investment in the nation’s infrastructure and improve its financing.” In “Cut to Invest: Revive Build America Bonds (BABs) to Support State and Local Investments,” Robert Puentes of the Metropolitan Policy Program at Brookings and co-authors also recommended BABs be renewed for infrastructure funding with “a guaranteed subsidy payment to insulate the bonds from federal budget cuts.”

A bipartisan group of senators introduced a bill in April 2021 (“American Infrastructure Bonds Act of 2021”) to authorize what they described as an improved version of BABs called American Infrastructure Bonds. Analogous to Direct Payment BABs, these bonds would feature a federal subsidy to reimburse issuers for 28% of the interest costs and could finance infrastructure projects. Unlike the BAB program, however, the subsidy payments would be exempt from sequestration, “which would increase the confidence in the bonds by the bondholder and bond issuer alike.” The Bipartisan Policy Center has also highlighted how Direct Payment BABs could better serve the country’s infrastructure needs post-pandemic—especially if they could finance a wider range of projects (instead of being limited to new construction).

In May 2021, President Biden proposed the revival of the BAB program, but only for funding school construction. Much like the bonds in the original program, Qualified School Infrastructure Bonds (QSIBs) would be taxable and feature either a tax credit to the bondholder or direct subsidy payments to the issuer from the federal government. However, the amount of these bonds would be capped nationally (at $50 billion in 2022) and, as the name suggests, their scope would be limited to education infrastructure. The federal government would also require states issuing QSIBs in 2022 to, first and foremost, use the proceeds to reopen schools safely.

In September 2021, the House Ways and Means Committee proposed to revive direct subsidy BABs. Starting in 2022, issuers of the new BABs would be permitted to use them to finance capital infrastructure projects and receive a direct federal payment to cover part of their interest costs. BABs issued over the 2022 to 2024 period would be subsidized at 35%, while those issued in 2025 onwards would feature a lower rate. The new program would cost the federal government over $22.5 billion between 2022 and 2031, according to estimates from the Joint Committee on Taxation. The proposal would effectively exempt the subsidy payments from future sequesters.