Is It Time To Buy Build America Bond ETFs? (BABZ, BABS, BAB)

Eric Dutram: Due to deteriorating sentiment over the global economic picture, many investors have begun to take another look at bond ETF investing. Products in the fixed income segment of the ETF world have, as a result, seen a huge boost in popularity, accumulating a great deal of assets in a very short period of time.

Generally speaking, these funds can offer investors less risk and comparable yields to broad stock funds, making them interesting choices should the economy continue to crumble and if stocks have more trouble picking up steam. This could be especially true if the Fed maintains its accommodative interest rate policy and keeps rates low for the near future, ensuring that bond investors aren’t punished by a quick rise in rates (see Three Bond ETFs for a Fixed Income Bear Market).

However, this low interest rate environment has also forced investors to look to higher risk or higher duration securities for their exposure in the fixed income world. After all, the 10 year Treasury bond is currently yielding around 1.5%, pushing investors into riskier junk bonds, foreign securities, or longer-dated corporates/Treasury notes in order to get yields back up to higher levels.

While any of the above bond segments could be an interesting way to play the trend, some investors may be better served by looking at the often overlooked Build America Bond segment instead.

BABs Explained

Build America Bonds are securities that were born in the immediate aftermath of the financial crisis in the American Recovery and Reinvestment Act of 2009. The bonds looked to give local and state governments a new way to finance their operations, theoretically with a lower cost to the issuers.

That is because these securities are structured as taxable bonds in which the federal government pays a subsidy of 35% of the interest paid on the bonds to the issuer. This effectively reduces the total interest rate cost for the issuing institution while keeping the securities extremely competitive with other types of fixed income for those who wish to purchase the bonds.

Through this process, municipalities can pay a lower rate of interest for their debt than what they otherwise would have, making these securities extremely popular among a variety of cities and states around the country. In fact, over $181 billion were issued in this type of security before the program closed down at the end of 2010, representing a decent chunk of the total muni bond market.

However, due to political issues and worries over the federal government’s budget, the program doesn’t look to be revived any time soon. This means that the current crop of BABs are all that will be out in the market, at least for the foreseeable future.

While this description of BABs may not do much for investors, it actually is pretty relevant to the security’s investment case, especially when comparing it to the overall bond market.

Generally speaking, these bonds are safer than their regular muni cousins as the interest rate cost to the issuing institution is much less, making them easier to service. Additionally, they tend to have comparable rates of interest as similar duration securities while still being safer than other relatively high yielding bonds (read Is The Bear Market For Bond ETFs Finally Here?).

Furthermore, due to a flat supply of the securities—and little prospect for more BABs in the near future, investors could see higher levels of demand continue in this bond segment, potentially keeping prices high for those seeking to make a play on the space.

Thanks to these factors, Build America Bond ETFs could be an interesting choice for those looking to find a new way to play the fixed income market. These BABs ETFs are often overlooked by exchange-traded fund investors but any of the following three funds could make for an easy, diversified way to play the in focus Build America Bond market in basket form:

PowerShares Build America Bond Fund (NYSEARCA:BAB)

This extremely popular ETF tracks the BofA Merrill Lynch Build America Bond Index which looks to follow the performance of dollar denominated BABs issued by U.S. states and their political subdivisions. In total, the product provides exposure to just over 325 securities while its modified duration comes in at 10.8 years.

Still, the majority of the bonds mature in at least 25 years from now with notes in the top ten focused on infrastructure and education. Overall, exposure is skewed towards California (25%), while Illinois and New York combine to account for another 18.5% of the fund (also read Three Defensive ETFs for a Bear Market).

While BAB is the most popular, it comes in the middle of the road for fees at 35 basis points a year. It has performed the worst of the three from a year-to-date look, adding 6%, although it does have the best yield at 4.3% in 30 Day SEC Yield terms.

SPDR Nuveen Barclays Capital Build America Bond ETF (NYSEARCA:BABS)

This ETF tracks the Barclays Capital Build America Bond Index which is a broad benchmark of the national BABs market. The product holds just under 200 securities in total and has a modest modified adjusted duration of about 13.7 years.

Bonds in the ETF are skewed towards ‘Aa’ rated products, although everything is investment grade in the fund. Californian bonds account for roughly one-third of the exposure while New York, Texas, New Jersey, and Illinois round out the top five (also read Are California Muni Bond ETFs In Trouble?).

BABS is also the low cost choice in the space, coming in at 28 basis points in fees per year. Since the start of the year, the product has also performed quite well, paying out a solid 4.1% in 30 Day SEC terms, while appreciating more than 9.2% in price.

PIMCO Build America Bond Strategy Fund (NYSEARCA:BABZ)

For investors looking for an active fund in the BABs market, PIMCO’s BABZ presents an interesting choice. The product zeroes in a handful of bonds in order to obtain exposure to the space, holding just 36 securities in total while having an effective duration of roughly 12.5 years (see Three Outperforming Active ETFs).

Like the other products on the list, the holdings in BABZ are tilted towards the long term, with over 80% of assets going to bonds that do not mature in less than 20 years from now. State exposure also goes to the usual suspects, as California makes up roughly 40% of the assets while New York and Illinois round out the top three, accounting for another third of the assets combined.

Due to the active strategy, BABZ is the most expensive pick in the Build America Bond ETF market, coming in at 45 basis points a year. Still, the fund has added close to 8.7% since the start of the year while it pays out a decent 4.1% in SEC 30-Day yield terms.

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Written By Eric Dutram From Zacks Investment Research

In 1978, Len Zacks discovered the power of earnings estimates revisions to enable profitable investment decisions. Today, that discovery is still the heart of the Zacks Rank, a peerless stock rating system whose Strong Buy recommendation has an average return of 26% per year.

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