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Transportation Funding & Financing

Build America Bonds

Overview

Build America Bonds are tax credit bonds introduced as part of the February 2009 American Recovery and Reinvestment Act (ARRA). A Build America Bond (BAB) is a bond issued prior to January 1, 2011 by a state or local entity for governmental purposes (non-private activity purposes) and for which the issuer elects to have the interest on the bond be taxable in return for a federal interest subsidy. Governmental purposes include the financing surface transportation projects. There is no volume cap on the amount of BABs that may be issued in 2009 and 2010.

Types

Tax Credit BABs

Tax Credit BABs are bonds for which the investor (bondholder) receives a tax credit equal to 35 percent of the amount of interest paid by the state or local government issuer, net of the tax credit. Tax Credit BABs can be used for the same purposes as tax-exempt borrowing (i.e., new construction, current refundings or one advance refunding, and working capital.) The federal interest subsidy on a Tax Credit BAB represents about 26 percent of total interest expense.

For example, if an investor required a ten percent return ($100) on a $1,000 bond, the issuer would pay $74.07 in interest and the investor would receive a supplemental credit equal to 35 percent of the interest the issuer paid, or $25.93, to provide the total desired annual return of $100. In this manner, the effective interest rate for the issuer is reduced by 26 percent. The investor can apply the tax credits against regular income tax liability and alternative minimum tax, and unused tax credits may be carried forward to the next year.

Direct Payment BABs

Direct Payment (or qualified) BABs provide a Federal subsidy through a refundable tax credit paid directly to state or local government issuers in an amount equal to 35 percent of the gross interest payable to investors, making the subsidy itself 35 percent. The credit is "refundable" in the sense that the issuer can present it directly to the Treasury for cash, and the Treasury has permanent indefinite budget authority to make the cash payment (i.e. there is no annual appropriation risk).

For example, under this approach on a $1,000 bond, the issuer would pay 100 percent of the taxable rate interest cost to the investor ($100) and apply for a refundable tax credit itself from the U.S. Treasury in an amount equal to 35 percent of the gross interest paid by the issuer ($35).

Comparison

Direct Payment BABs provide a higher subsidy than the Tax Credit BABs (35 percent vs. 26 percent), and are much more readily marketable, as there is no need for investors to ensure they have sufficient tax liability to make the tax credit worthwhile. However, Direct Payment BABs are more limited in purpose because the proceeds are effectively restricted to new construction projects (i.e., no refinancing or working capital). From an investor's perspective, the Direct Payment BAB is indistinguishable from a conventional taxable bond, as the annual return is paid entirely in cash. Through May 2009, all BAB activity has been of the Direct Payment variety. The diagram below illustrates the two variants of BABs:

Illustration of Build America Bonds: Tax Credit vs. Direct Payment Structure with 10% Return


Previous Proposal

It should be noted that the BABs enacted as part of the ARRA differ from the Build America Bonds Act proposal introduced in January 2009 by Senators Ron Wyden (D-OR) and John Thune (R-SD) (S. 238) to assist transportation projects. Their proposal entailed a tax credit equal to 100 percent, not 35 percent, of the borrower's interest cost, providing a greater subsidy. In addition, issuance volume was capped at $50 billion of bonds to be issued over six years. The maximum term of these bonds was to be 30 years. All these bonds were to be issued through a centralized nationwide issuer, the Transportation Finance Corporation, rather than the direct issuance process by state and local governments being used for the ARRA-enacted BABs program.

Resources

Build America Bonds: A Preliminary Assessment
Much of the content of this section is taken from this briefing paper prepared for AASHTO by Mercator Advisors LLC. The paper also provides greater detail on the purpose of including Build America Bonds as part of the ARRA, as well as market history, net borrowing rates, and issuance activity for their first two months of use, April and May 2009.

The U.S. Treasury announced on April 3, 2009 its Guidance on Build America Bonds. The guidance is designed to enable state and local governments to use the new program. It describes the two types of BABs, the procedures for applying for the refundable credit, and reporting information.

In addition, the U.S. Treasury announced on June 13, 2009 its guidance and notice of allocation of Recovery Zone Economic Development Bonds which are similar to Build America Bonds.

Section 1531 of the American Reinvestment and Recovery Act of 2009 codifies Build America Bonds into law.