Buy Side

Invesco Bringing BABs to ETFs

Invesco Ltd. today launches an exchange-traded fund designed to track the performance of taxable Build America Bonds — a potentially transformative product that has helped galvanize public finance in 2009.

The PowerShares Build America Bond Portfolio kicks off trading this morning on the NYSE Arca exchange.

Like any ETF, this one seeks to mimic the performance of an index, in this case the BofA Merrill Lynch Build America Bond Index.

The index, provided by Bank of America Merrill Lynch, shows total returns on most of the $52.16 billion of BABs that have been issued since April.

Created through the American Recovery and Reinvestment Act this year, the BAB program allows issuers to forgo the traditional tax exemption on their debt and instead sell taxable bonds and receive a subsidy from the Treasury equal to 35% of the interest costs.

By tapping new classes of tax-deferred or tax-advantaged buyers such as pension funds, many issuers have found it is more cost-effective to sell BABs than tax-exempt bonds, especially for longer-term debt.

The BofA Merrill index implies someone who invested in BABs when they were first issued in late April would have earned a return of 4.4% so far.

This is at least the 19th municipal bond exchange-traded fund, and Invesco’s fifth.

Bond ETFs try to replicate the performance of a target index by investing in a sample of bonds that are similar to the much-bigger population of bonds in the index.

For instance, the Invesco Powershares BAB ETF launches with $5 million in seed money from its specialist, Kellogg Group. The fund invested that $5 million in 25 BAB issues. The 25-bond portfolio is intended to mirror the day-to-day movements in the BofA Merrill index, which tracks 1,797 BABs with $42.96 billion in face value.

ETFs with comparatively small ­portfolios track their bigger indexes ­using a process known as representative ­sampling. That entails stratifying the bonds in the index into categories such as maturity, coupon, duration, and credit risk, and populating the ETF portfolio with the appropriate number of bonds from each strata. That way, fluctuations in the index will be reflected by fluctuations in the ETF.

Ben Fulton, executive vice president of global product development at Invesco, said the fund hopes to achieve a correlation of at least 98% with the target index.

The ETF will be managed by a team headed by Phil Fang, who also manages the company’s other muni ETFs.

Aside from the normal risks facing an ETF with a few million dollars trying to match an index following many billions, this fund faces a unique prospect — nobody knows whether the BAB program will exist in two years.

The legislation that created the BAB program is slated to expire at the end of 2010. Extension of the program, possibly at a lower subsidy rate, has been widely discussed. Still, the sunset provision creates the risk BABs will become an orphaned product on New Year’s Day 2011.

The fund allows itself some flexibility to cope with this eventuality. Should the program expire, the fund can adjust to tracking a general taxable municipal index.

The municipal team at Powershares first tossed around the idea of a taxable municipal bond fund two years ago, Fulton said. The problem was there were not many taxable municipal bonds to choose from.

“We’d been asking about a taxable fund, but there really wasn’t enough depth in the market,” Fulton said.

Municipalities sold $135.35 billion of taxable bonds in the five years ending 2008, according to Thomson Reuters, or 7% of all municipal bonds. Last month, 37% of muni bonds floated were taxable, including most of the biggest deals.

The BAB program established the market depth Invesco needed to create a taxable muni ETF, Fulton said.

Fulton said that while this product has garnered inquiries from institutional investors and pension funds, he believes the main appeal is to rich people with money saved in tax-deferred accounts.

Fulton acknowledges the fund got lucky — the ticker symbol “BAB” was ­available.

Practically nonexistent two years ago, the municipal ETF industry now manages $5.29 billion, according to the Investment Company Institute.

The sector’s assets have more than doubled since January.

Most muni ETFs hit their all-time highs during the municipal rally in late September and early October, and have since backed off.


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