Falling tax revenues have opened gaping holes in states’ and municipalities’ balance sheets–a daunting challenge because many are under constitutional obligation to balance their budgets. Here’s a way to build profits while building America.

States and municipalities across the US have been hard it by the housing crisis, the credit crunch and The Great Recession. While plummeting property values and economic weakness have weighed heavily on tax revenues, the implosion of the bond insurers made it extraordinarily expensive to raise money.

Enter Build America Bonds (BABs), a new form of municipal bond authorized by the American Recovery and Reinvestment Act of 2009. Unlike traditional municipal bonds, which are usually tax exempt, interest received on BABs is subject to federal taxation. However, as with municipal bonds, most states exempt interest paid on BABs issued within their jurisdiction from taxation.

What’s the allure of BABs for investors?

For starters, they generally offer significantly higher yields than standard municipal bonds; many of these longer-dated bonds yield over 7 percent, thanks to one of two government subsidies.

Under the direct payment variation, the government provides the issuer a subsidy equal to 35 percent of the interest payments on the bond. More often than not the issuers pass much of that subsidy along to bondholders in the form of higher interest payments. Alternatively, under the tax credit scheme, bondholders receive a nonrefundable tax credit equal to 35 percent of the interest paid by the bond. For obvious reasons the direct payment option has been the most popular with issuers.

These new bonds have also been popular with investors because, if you put much faith in the rating agencies, they’re reasonably safe and carry ratings from A to AAA.

Those qualities make the bonds extremely attractive to institutional investors and make it nearly impossible for retail investors to get their hands on a piece of individual issues. Pension funds and other tax-exempt organizations have scooped up as much of the bonds as they can get their hands on because they offer high yields with little risk. The popularity of BABs has grown to the point that they’re displacing an ever-growing slice of traditional bonds in government debt issuance.

There are currently only two reliable ways for individual investors to get a piece of the BAB action.

The best way is through PowerShares Build America Bond (NYSE: BAB), an exchange-traded fund (ETF) that holds a sampling of the bonds that make up the Bank of America Merrill Lynch Build America Bond Index. This index tracks only direct-pay BABs; holding the ETF doesn’t convey any tax benefits. But the ETF’s yield currently trumps the S&P 500’s yield by almost 3 percent, and the fund carries an expense ratio of just 0.35 percent.

Readily traded thanks to ample liquidity, PowerShares Build America Bond is an excellent example of how a fixed-income ETF should operate.

Alternatively, investors might consider Eaton Vance Build America Bonds A (EBABX), an open-ended mutual fund. Relative to the PowerShares ETF, this option is vastly inferior. With a front-end load of 4.75 percent and an annual expense ratio of 1.24 percent, the fund is prohibitively expensive. And a paltry yield of 1.6 percent hardly justifies the fund’s cost.

The primary risk to investing in either of these funds is that the underlying bonds may be available for a limited time only; the authorizing legislation only allows them to be issued through year-end. If that authorization isn’t extended, the supply of bonds available to the funds could dry up. Most analysts agree that the program likely will be extended–at least until tax revenues stabilize.

WHY TO BUY
POWERSHARES BUILD AMERICA BOND ETF (NYSE: BAB, $24.27)

• Build America Bonds offer higher yields than similar low-risk issues

• Prices are off recent highs, offering attractive valuations