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Build America Bonds

Parlez-Vous BABs? A Fund Wants to Know

For anyone still not convinced that Build America Bonds are transforming state and local government finance, behold a municipal bond mutual fund that has filed a prospectus in French.

This month, a Toronto-based firm called Connor, Clark & Lunn Capital Markets launched a Canadian mutual fund dedicated to Build America Bonds — or, as they are known in French, “Les obligations Build America.”

The fund raised C$31.8 million ($30.6 million U.S.), in its initial public offering — far less than the C$125 million ($120.1 million) in shares the firm made available.

Still, the launch was the most concrete illustration yet of the foreign investors who reportedly have emerged to buy BABs.

“It makes perfect sense for a Canadian investor,” said Darren Cabral, vice president at Connor, Clark & Lunn, citing U.S. municipal default rates well below those on comparably rated corporate bonds and a “fairly attractive yield.”

Because of the legal structure of mutual fund trusts in Canada, the monthly dividends paid on the fund will mostly be tax-exempt, according to the Canadian law firm McCarthy Tetrault LLP, which was counsel on the initial public offering.

Cabral attributes the small amount of money the fund raised to Canadians’ unfamiliarity with U.S. municipal bonds.

As the BAB program seasons, Cabral said he foresees Canadians becoming more comfortable with U.S. municipal issuers. More offerings like this one are definitely on the radar, he said.

According to the Federal Reserve, foreign investors owned $53.5 billion in municipal debt at the end of the third quarter. That was the highest total ever, and at 1.93% represented the greatest share of the overall municipal debt market in foreign hands in history.

The fund that launched this month — the complete name of which is the Build America Investment Grade Bond Fund — is listed on the Toronto Stock Exchange and invests most of its assets in high-grade BABs.

The fund has employed Nuveen Investments as sub-adviser. The Chicago-based company, which manages $68.8 billion in municipals, will use its staff of analysts to find undervalued BABs.

In the prospectus — the one filed in English — the fund states that Nuveen believes the scale and intricacy of the BAB market leads to pricing anomalies and inefficiencies that can be exploited with the right trading strategies.

While the fund has yet to publish its holdings, Nuveen constructed an “indicator portfolio” in December comprising the BABs it would have bought had the fund been capitalized at the time.

The indicator portfolio included 43 bonds from issuers like California, Phoenix, the Utah Transit Authority, the New York City Municipal Water Authority, and the Florida Board of Education.

The bonds carried an average yield to maturity of around 6.5% and an average rating of double-A minus from Standard & Poor’s.

The fund expects to pay a monthly dividend of 11.98 Canadian cents, representing a 5.75% yield on the IPO price. The fund will terminate on Feb. 27, 2015, liquidating its assets and distributing the proceeds to shareholders, unless they elect to extend it.

A Canadian fund investing in U.S. state and local government securities faces a risk unfamiliar to many American municipal portfolio managers: currency risk.

The fund plans to hedge “substantially all” of the risk that a strengthening of the Canadian dollar will render coupon payments in U.S. dollars less valuable. The fund also may use derivatives to hedge the risk of a spike in interest rates.

Among the numerous differences between Canadian and American mutual funds, Canadian funds are able to employ leverage. American mutual funds cannot utilize leverage because they need to redeem shares upon request.

The Canadian fund also has to redeem shares, but it employs a structure vastly different from the typical U.S. mutual fund. The fund does not actually own the securities. The securities are placed in a trust, which is sold to an affiliate. The fund then buys a forward contract from the affiliate, and the dividends are generated by the returns on the forward contract.

The forward contract can be adjusted to magnify returns or losses on the trust, which is how the fund implements leverage. The fund expects to begin with leverage of 25%. The maximum leverage will be 33%.

The fund differs from the typical U.S. municipal fund in one other key respect. Most U.S. funds do not begin the announcement trumpeting their launch with: “Not for distribution to United States newswire services or dissemination in the United States.”

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