On September 21st, PIMCO launched its fourth actively-managed ETF in the US, the PIMCO Build America Bond Strategy Fund (NYSE:BABZ). This is the first actively-managed ETF to hit them market from PIMCO, since the launch of the Short Term Municipal Bond Fund (NYSE:SMMU) back in January of this year. PIMCO has had this product in filing with the SEC since the early part of this year, and still has two more actively-managed funds that are being planned.
The Build America Bond Strategy Fund will provide exposure to municipal debt securities that have been issued under the “Build America Bond” program that was created as part of the American Recovery and Reinvestment Act of 2009, more simply known as the “stimulus package”.
Build America Bonds (BABs) are typically issued by municipalities to finance their expenditures. So how are BABs different from traditional municipal bonds? The appeal of the traditional municipal bonds is that their interest income is exempt from federal taxes and from most state and local taxes. This brings favourable tax implications for investors, especially those who are in higher tax brackets. In comparison, income generated from BABs is taxable. However, BABs have their own advantages.
What so good about Build America Bonds?
There are two types of Build America Bonds that have hit the market. The first category of bonds (called “Direct Payment BABs”) have higher than normal interest rates, which are partly subsidised (to the tune of 35% of the interest rate) by the federal government. Due to the subsidy, the issuing municipalities are able to promise high interest rates that are often comparable to corporate bond offerings. For example, one of the first BAB issues to be launched was a $250 million offering from University of Virginia in April 2009 that had a taxable interest rate of 6.22%. However, including the 35% federal subsidy would reduce the effective interest rate for the issuer to 4.03%. So municipalities have been able to attract investors to BABs with every competitive interest rates without having large interest liabilities, thanks to the federal government footing the bill.
The second category of BABs (called “Tax Credit BABs”) provided a federal subsidy of 35% of the interest payable directly to the investors instead, through tax credits. Thus, the bond owner’s tax liability on the interest income is effectively reduced by utilizing the tax credits.
The Direct Payment BABs have been more popular because large institutional buyers, especially tax exempt buyers like pension funds, have been attracted to the higher interest rates; So much so that since the launch of the Build America Bond program, issuance of traditional tax-exempt municipal bonds has dropped. Since the program’s inception, more than $125 billion in BABs have been issued – which represents about 20% of all muni-bond issuance, according to PIMCO.
How can you get your hands on some BABs?
At the moment, there are only two ETFs that provide exposure to Build America Bonds and both of them are passively-managed instruments. The first is the PowerShares Build America Bond Portfolio (NYSE:BAB), which tracks the BofA Merrill Lynch Build America Bond Index. The second is the SPDR Nuveen Barclays Capital Build America Bond ETF (NYSE:BABS), which tracks the Barclays Captial Build America Bond Index. Both of these funds have an expense ratio of 0.35%, but BAB has been a much bigger success with more than $550 million in assets, compared to $20 million in BABS. Both of these index ETFs are focused on BABs that have maturities of around 20 years.
PIMCO’s Build America Bond Strategy Fund (BABZ) aims to differentiate itself, in a space that is already quite crowded, by offering the potential for active management amongst BABs. BABZ will invest primarily in investment-grade securities, but also has the freedom to invest up to 20% of its assets in high-yield bonds, in search of excess returns. The average maturity of the fund is targeted to match the average maturity of the Barclays Capital Build America Bond Index, plus or minus 2 years. The portfolio manager, John Cummings, will look for bonds that offer attractive current income and are trading at competitive prices. In return for the active management provided, the fund will charge investors marginally more than the passive alternatives, with an expense ratio of 0.45% (after including a 0.10% “expense reimbursement”).
What’s the active management value add?
The argument that PIMCO makes for its actively-managed ETF over the passive alternatives is much the same as that for its other municipal bond ETFs. Issuer-specific credit analysis in the municipal bond space is crucial to be able to avoid owning poor credits, which can be commonplace given the budgetary difficulties many of them are facing.
Active management will also allow the mangers to position the portfolio strategically according to macro changes that they see coming. For example, investors holding the passively-managed BAB ETFs from PowerShares and State Street may be exposed to falling bond values when interest rates eventually rise. This is especially because both those funds have average maturities exceeding 25 years. With BABZ, PIMCO’s managers will have the ability to move the portfolio along the yield curve and utilize duration positioning based on their economic outlook.
Another interesting point is that the Build America Bond Program actually expires on January 1, 2011, meaning that any new issuances of BABs have to be completed before that date. After that, the BABs market will be limited to those bonds that have been issued since 2009 – which is no small number by any means, still. Safe to say that there’ll be sufficient issues available in the secondary markets to provide investment opportunities, until they reach maturity 20 years out. Even then, the US Congress is in the process of considering an extension of the program to December 31, 2012. How that decision plays out will also affect how managers manage BAB portfolios.
Shishir Nigam is the founder of ActiveETFs | InFocus (http://www.etfshub.com/), which provides extensive coverage and analysis of actively-managed ETFs in US and Canada, including debates on major industry trends, insights on the latest product launches from issuers in the Active ETF space as well as in-depth interviews with industry executives and thought leaders.
Disclosure: No positions in above-mentioned names.
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