The American Recovery and Reinvestment Act of 2009 created Build America Bonds (BABs), a relatively new type of taxable municipal bond. They are intended to finance state and municipal government projects that would otherwise be unaffordable, as well as to aid the economy in general.
“Direct Payment” and “Tax Credit” are the two categories of BABs. Direct Payment BABs offer the government subsidy to the issuer directly, whereas Tax Credit BABs provide the federal subsidy to the bondholder as a refundable tax credit.
The federal government provides a direct subsidy of 35% of the BAB coupon to eligible state and local government issuers and governmental agencies to minimize the cost of borrowing. As a result, issuers are able to provide greater interest rates, making BABs more appealing to both institutional and individual investors.
Holders of Build America Bonds, unlike owners of tax-free municipals, are subject to federal income tax on the interest they receive. Holders who live in the state where the bond was issued, on the other hand, may be immune from state and local interest taxes. Working capital, private activities, and 501(c)(3) organizations are not eligible for BABS refunds. BABS are frequently provided by critical service providers, such as water and power companies, implying that a steady stream of cash is available to support interest payments. The majority of BABs have a maturity of more than 20 years.
BABs, like other bonds, are subject to default. Municipal default rates, on the other hand, have generally been much lower than corporate bond default rates. When municipal bonds have defaulted, the average recovery rate has been higher than that of defaulted corporate bonds. Rating agencies have usually given investment-grade ratings to BABs that have been issued thus far.
The BABs program expired at the end of 2010, and there have been no efforts to prolong it in Congress.
Are state bonds taxable?
Federal income from state, city, and local government bonds (municipal bonds, or munis) is normally tax-free. However, you must record this income when you file your taxes.
In most cases, municipal bond income is tax-free in the state where the bond was issued. However, take in mind the following:
- Occasionally, a state that normally taxes municipal bond interest would exempt special bonds when they are issued.
Municipal bond income may potentially be free from local taxes, depending on your state’s regulations. For further information on the rules in your state, see a tax advisor.
How do BABs get taxed?
On BABs, the investor receives both taxable interest income (Tax Credit) and a tax credit equivalent to 35% of that interest. The investor’s gross income includes both the interest and the tax credit. In most cases, the tax credit can be applied to both regular and alternative minimum taxes.
What was the purpose of Build America Bonds?
BABs were debt securities used to fund capital expenditures by a state, municipality, or county. The federal government subsidized the interest rates on these bonds, lowering the cost of borrowing for infrastructure projects for state and municipal governments.
Is it wise to invest in Build America Bonds?
BABs were found to be quite effective in some studies. The US Treasury projected that BABs saved state and local governments more than $20 billion in interest spending over the long term by comparing yields on tax-exempt and BAB bonds issued by the same issuers. Similar to the Treasury’s investigation, economists Gao Liu of Florida Atlantic University and Dwight Denison of the University of Kentucky found that BABs saved issuers 65 basis points on a typical bond when compared to standard tax-exempt bond issues.
However, Martin Luby of the University of Texas at Austin (and a state and local government advisor), Peter Orr of Intuitive Analytics, and Richard Ryffel of Washington University in St. Louis argue that this estimate is too high because it ignores the fact that BAB debt is more difficult to refinance than traditional tax-exempt bonds.
BABs were given out with “Make-whole call clauses” state that if the issuer wants to pay down the remaining debt before the bond matures, they must pay investors the total interest collected over the bond’s tenure. This made paying off BABs early far more expensive, preventing issuers from taking advantage of reduced interest rates as they declined over time.
After accounting for the call option and future refinancing, Luby and co-authors estimate that BABs save 35 basis points vs a standard tax-exempt bond issue, which is significantly less than other estimates. BABs must be revived if they are to be used again in the future “The authors conclude that federal authorities will need to be more active than previously anticipated in determining a subsidy rate that will encourage state and local governments to issue.
Which government bonds are exempt from paying taxes?
A government entity issues tax-free bonds to raise revenue for a specific purpose. Municipal bonds, for example, are a type of bond issued by municipalities. They have a fixed rate of interest and rarely default, making them a low-risk investment option.
The most appealing aspect, as the name implies, is the absolute tax exemption on interest under Section 10 of the Income Tax Act of India, 1961. Tax-free bonds often have a ten-year or longer maturity period. The money raised from these bonds is invested in infrastructure and housing initiatives by the government.
Are bonds subject to capital gains tax?
While interest income from municipal bonds is normally tax-free, capital gains from bond sales are subject to federal and state taxes. The difference between the selling price of the bond and the original purchase price of the bond is the short-term or long-term capital gain or loss on a bond sale.
Are municipal bonds exempt from taxes?
Municipal bonds (sometimes referred to as “munis”) are fixed-income investments that offer better after-tax returns than comparable taxable corporate or government issues. Interest paid on municipal bonds is generally excluded from federal taxes and, in some cases, state and local taxes as well.
What types of bonds are eligible for early repayment?
- A callable bond is a debt product that, at the issuer’s discretion, can be redeemed before its maturity date.
- A callable bond allows businesses to pay off their debt early and take advantage of lower interest rates.
- Because a callable bond favors the issuer, investors are compensated with a higher interest rate than on otherwise comparable non-callable bonds.