Build America Bonds: Municipal gains

by Carla Pasternak, editor High-Yield Investing

We first covered Build America Bonds in June 2010; at that time, PowerShares Build America Bond Fund (BAB), was the only ETF that tracked these bonds. Over the past year and a half, it has delivered handsome returns of 19%.

Income investors now can also choose SPDR Nuveen Barclays Capital Build America Bond ETF (BABS) and Pimco Build America Bond Strategy Fund (BABZ), which offer equally strong returns.

The program has proven to be one of the more successful outcomes of Obama's $800 billion stimulus package in 2009. The bonds were designed to stimulate the economy by creating employment at the grassroots local level.

Like other municipal bonds, the debt is used to finance local construction projects, such as bridges and roadways. And with up to 35% of the interest backed by the U.S. government, most Build America Bonds carry the highest "AA" and "AAA" credit ratings.

The program was slated to expire in December 2010. Hopes for an extension were dashed after November 2010's mid-term elections.

As a result, a cloud of uncertainty was expected to hang over the ETFs holding the bonds. Investors were warned that the number of bonds available in the market could be limited and the lack of liquidity could negatively affect the value of the bonds.

In fact, the reverse has happened. Precisely because no new Build America Bonds have been issued since the 20-month program expired at the end of 2010, investors have bid up prices.

Also, most Build America Bonds are long-term debt that matures in 20 years and longer. As such, they offer higher yields than shorter-term debt to yield-starved investors in today's low interest-rate environment.

While yields have come down from the 5.4% peak in late August as investors have bid up the prices, these bonds still offer a rich 4.8% yield, on average. By comparison, 30-year U.S.-Treasury yields average just 3.0%.

The easiest way to benefit from the success of these bonds is through one of these three ETFs -- BAB, BABS, or BABZ.

All three track long-term bond portfolios, with the majority of maturities ranging from 20 to 30-plus years, an average credit rating of "AA," and an average coupon rate between 5% and 8%.

PowerShares Build America Bond Fund is the largest of the three, with $700 million assets under management and more than 200,000 in daily trading volume. The portfolio is diversified among 300 holdings.

SPDR Nuveen Barclays Capital Build America Bond ETF is relatively small, with only $40 million in total assets and a daily trading volume of around 11,000. The fund focuses on 173 holdings.

PIMCO Build America Bond Strategy Fund is the smallest of the three, with less than $26 million in assets, less than 30 holdings.

Unlike the other two funds, which track an index, BABZ is actively managed. As such, it has a slightly higher expense ratio of 0.45% of the asset value, versus 0.35% for BAB and BABs.

So far, however, the active management has paid off, with marginally stronger year-to-date returns than the other two.

Risks to Consider: These long-term bond funds are "risk-off" plays in a low rate environment. If the euro crisis gets resolved and the U.S. economy continues on a growth track, investors will likely rotate out of long-term bonds into higher-risk growth plays.

Moreover, given the long-dated maturities of the bond holdings, their asset values, and share prices, could come under pressure as interest rates rise.

Action to Take --> All three Build America Bond funds offer secure monthly income at attractive yields, even after accounting for the tax treatment as ordinary income.

But if I had to pick one, I would opt for PowerShares Build America Bond fund, as it offers the best risk diversification.

Learn more about this financial newsletter at Carla Pasternak's High-Yield Investing.