The new kid on the block in the municipal-bond market

Tucked in among the 400-plus pages of the "stimulus" act passed earlier this year (see Part V, Sec. 1531) is the authorization for Build America Bonds, a new kind of taxable municipal bond subsidized by the federal government. (Right now, the authorization is for 2009 and 2010 only.)

Billions of dollars worth these bonds have already been issued and, due to the subsidy, most are paying higher interest than traditional municipal bonds. Although that interest may be free from state and local taxation, the bondholder must pay federal tax (that's not the case with traditional munis).

The higher interest may be attractive, but a primer on Build America Bonds issued by the Securities Industry and Financial Markets Association suggests that BABs aren't really appropriate for most individual investors.

Individual investors who might be considering these bonds should understand that Build America Bonds are new and complex instruments, are not conventional municipal bonds and are not as liquid as municipal bonds. These bonds might be considered for part of an individual investor's buy and hold strategy if they hold bonds for maturities of 20 years and longer....

Individual investors should consult their financial or investment advisors for more information to determine whether these investments are appropriate for their particular circumstances.

Is there a mutual fund that invests strictly in Build America Bonds? No, not so far.

BABs have had a strong showing since their introduction just a few months ago, with more than $17 billion worth already sold, according to Bloomberg. Texas, California, and New Jersey had issued more than $1 billion each, as of June 30.

Taking a larger view of the municipal-bond landscape, George Mason University professor John E. Petersen thinks BABs have the potential to ultimately kill the traditional tax-exempt bond market. He explains why in a recent article in Governing magazine.

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Joseph Slife is a contributing author and editor for SMI. Visit www.soundmindinvesting.com to learn more.