What Is a BAB Bond? Issuance, Tax Factors, and Redemption Explained

Build America Bonds (BABs) were a taxable municipal bond introduced in 2009 under the American Recovery and Reinvestment Act. They provided state and local governments with an alternative way to finance public projects while benefiting from federal subsidies. Unlike traditional municipal bonds, BABs did not offer tax-exempt interest but featured direct payments or tax credits to offset borrowing costs.

Issuance Criteria

State and local governments could issue BABs only for new capital projects like roads, bridges, schools, and public utilities. Refinancing existing debt or covering operational expenses was not permitted, ensuring the funds supported long-term infrastructure improvements.

Authorized between April 2009 and December 2010, BABs required issuers to submit reports to the IRS documenting how proceeds were used to comply with federal guidelines.

Interest rates were determined through public offerings, influenced by credit ratings, market conditions, and investor demand. Unlike tax-exempt municipal bonds, which primarily attracted U.S. individual investors, BABs appealed to a broader range, including pension funds and foreign buyers. This expanded investor base helped municipalities secure competitive borrowing costs despite the taxable status.

Mechanisms for Interest Subsidies

The federal government subsidized BABs to lower borrowing costs for state and local governments through two models: Direct Payment BABs and Tax Credit BABs.

Direct Payment BABs were the most widely used. Issuers received a federal reimbursement of 35% of the interest paid to bondholders. For example, if a city issued bonds with a 6% interest rate, the federal government reimbursed 2.1%, lowering the net cost to 3.9%.

Tax Credit BABs provided investors with a federal tax credit equal to 35% of the interest earned. However, this model was less popular since many investors preferred direct cash payments over tax credits, particularly those without sufficient tax liabilities to fully utilize the benefit.

Tax Liability Factors

Unlike traditional municipal bonds, BABs required investors to report interest earnings as taxable income. In 2024, federal income tax rates ranged from 10% to 37%, meaning high-income investors saw a significant portion of their BAB interest earnings reduced by taxation.

State and local tax treatment varied. Some states exempted BAB interest from state income tax if issued within their jurisdiction, while others taxed it as regular investment income. For example, a California resident holding BABs from another state could be taxed at California’s top marginal rate of 13.3%, reducing the effective return. Investors needed to assess state-specific tax codes to determine their net earnings.

Capital gains or losses from selling BABs before maturity were also taxable. Gains were subject to capital gains tax, with 2024 rates set at 0%, 15%, or 20%, depending on income level. Selling a bond after holding it for one year or less resulted in short-term capital gains taxes, which matched ordinary income tax rates. Losses could offset other capital gains or be deducted against ordinary income up to $3,000 per year under IRS guidelines.

Market Trading Basics

The secondary market for BABs differed from traditional municipal bonds due to their taxable nature and broader investor base. While tax-exempt municipal bonds primarily attracted U.S. individual investors, BABs appealed to institutional buyers such as pension funds, insurance companies, and foreign investors.

BAB prices were closely tied to Treasury yields and corporate bond spreads rather than the municipal bond index. Because BABs carried a taxable coupon, they were often compared to corporate bonds of similar duration and credit risk. Rising Treasury yields typically led to lower BAB prices, mirroring corporate debt market trends. Credit ratings from agencies like Moody’s, S&P, and Fitch also played a role—downgrades in an issuer’s credit rating could cause price declines, while upgrades often boosted market value.

Redemption Provisions

BABs included redemption features that affected their long-term value. These provisions varied by issuance but typically included call options, make-whole calls, or sinking fund requirements.

Call options allowed issuers to redeem bonds at a predetermined price after a set period, often at par or a slight premium. This benefited municipalities if interest rates declined, enabling them to refinance at lower costs. However, callable bonds carried reinvestment risk for investors, as they could be forced to reinvest proceeds at lower yields.

Make-whole calls required issuers to compensate investors based on the present value of remaining payments, reducing the likelihood of early redemption. Some BABs also incorporated sinking funds, mandating periodic principal repayments to lower default risk and provide structured cash flows.

Maturity Structures

Maturity structures for BABs varied based on issuer needs and market conditions, influencing risk and return profiles for investors. Bonds were issued with short-, medium-, and long-term maturities, often aligning with the lifespan of funded infrastructure projects.

Longer maturities, often exceeding 20 years, were common for large-scale developments such as highways and transit systems. These bonds typically offered higher yields to compensate for duration risk, making them attractive to pension funds and insurance companies seeking stable, long-term income.

Some issuers structured BABs with serial maturities, where portions of the debt matured at different intervals, providing a staggered repayment approach. Others opted for term bonds, where a single maturity date applied to the entire issuance, often paired with sinking fund provisions to manage repayment obligations.