The Build America Bonds (BABs) program, a new piece of legislation from the Obama Administration, focuses on aiding struggling state and local municipalities across the U.S. The program, part of the American Recovery and Reinvestment Act of 2009, creates taxable municipal bonds, a radical departure from the long-standing tax exempt status quo for munis.

While bonds issued under the BABs program are fully taxable, the issuer receives a direct subsidy equal to 35% of the bonds coupon, or stated interest rate. The intent is to make some of the benefits of traditional muni bonds available to investors outside the highest tax brackets.

For many years there has been talk within the Treasury Department and the IRS that the tax exemption for municipal bonds is an inefficient subsidy since it allows only the highest taxpayers to benefit from the tax exempt income. At current tax rates, top bracket earners avoid paying 35% on that income. That benefit obviously will increase if/when taxes go up.

The BABs program will have significant benefits if it is embraced by lower bracket earners who need taxable income from their investments. The program will make it easier for municipalities to raise needed funds by bringing in a large new group of investors that have not previously participated in the municipal bond arena.

There is some question about what effect this program might have on existing tax exempt municipal bonds. The BABs program only allows bonds to be sold for new projects, not to refinance debt incurred in the past. An issuer can’t issue BABs to call old debt. Therefore, if the BABs program gains significant momentum, the municipal bonds currently in the marketplace are less likely to be redeemed early. As a result many of the bonds already issued are, in-effect, non-callable. More importantly, if new issues of tax exempt bonds are virtually non-existent, the demand for existing issues by the highest tax payers could increase significantly.

Some critics of the program argue that while BABs might have some benefits for those outside the highest tax brackets, the wealthiest individuals will still reap the most rewards. While this might be the case, I applaud the program’s goal of trying to bring the median income individual into the muni bond market. This could very well be a nice addition for those living on their income from investments (like CD’s, etc.) and a huge win for municipalities in those parts of the country that are struggling right now.

That said, the biggest winners just might be those that already own the old-style, tax exempt version of municipal bonds. We are telling our clients to hold on to their high quality Arizona tax free bonds.