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As part of the President’s and the U.S. Congress’s 2009 economic stimulus efforts, Congress passed and the President signed into law the American Recovery and Reinvestment Act of 2009 (the “ARRA”). Part of the ARRA included provisions to assist state and local governments across the country by authorizing the issuance of new federally-taxable bonds by state and local governments.

The ARRA authorized the issuance of a new type of bond by state and local governments referred to as “Build America Bonds” or “BABs.” BABs, unlike traditional municipal bonds, are “taxable” bonds, meaning that the interest paid by the issuer of the bonds to the holders of the bonds is subject to federal income tax. In contrast, interest paid on traditional municipal bonds is typically exempt from federal taxation.

The financial markets have responded to this new form of taxable municipal debt, as the now-taxable BABs attract a broader group of investors that do not typically buy tax-exempt municipal bonds. State and local governments are now able to offer higher-rate taxable bonds that have strong credit quality and may have more appeal to investors than taxable corporate bonds, which have historically higher default rates. Analysts have noted that buyers of BABs often include foreign banks and pension funds that ordinarily receive no tax advantage by investing in tax-exempt municipal bonds. Thus, taxable BABs provide a new means for investors to diversify away from some of the riskier credit exposures. With greater demand for BABs, interest rates bid for the bonds may be competitive, thereby offering issuers an opportunity for interest savings over the terms of the bonds, notwithstanding the taxable status of the bonds.

The interest savings is due, in large part, to the federal interest payment subsidy provided by the ARRA. The ARRA created two types of BABs, but one of the two types, “Direct Payment BABs,” has been more widely used by state and local governments.

Direct Payment BABs provide a direct federal subsidy that is paid to the issuer of the bonds in an amount equal to 35% of the interest cost on the bonds. With Direct Payment BABs, the issuer of the BABs applies to the Department of Treasury for reimbursement of a portion of the interest on the bonds paid by the issuer. Taking into account the direct payment subsidy, the interest cost on the Direct Payment BABs is expected to be lower than the interest that would otherwise be payable by the issuer on a tax-exempt bond issue.

Under the ARRA, Direct Payment BABs must be issued no later than December 30, 2010, which means that to the extent a local government would like to take advantage of the federal interest subsidy, the local government should begin the financing process within the next couple of months to meet the December 30, 2010 deadline.

On March 24, 2010, the U.S. House of Representatives passed H.R. 4849, which would extend the BABs program until April 1, 2013. However, unlike the federal subsidy for Direct Payment BABs under the ARRA, the amount of the direct-pay subsidy paid by the federal government would shrink from 35% to 33% in 2012, and to 30% in 2013. The House legislation has been referred to the U.S. Senate for consideration.

President Obama also included an extension of BABs in the fiscal year 2011 federal budget, albeit at a lower federal interest subsidy. Under the President’s budget proposal, the federal interest rate subsidy would fall from 35% to 28%. Unlike the House legislation, the President’s proposal would make the 28% subsidy level permanent, with no end date.