When Build America Bonds hit the market a year ago, Eaton Vance did not have to do much homework before launching its mutual fund devoted to the new product.
The Boston-based company’s tax-exempt group already had portfolio managers and a team of 10 municipal analysts familiar with state and local government issuers and the forces that drive municipal credit quality.
The company named Cynthia Clemson and Craig Brandon — who each manage a dozen tax-exempt mutual funds — managers of the BAB fund when it launched in November.
The $7 million Eaton Vance fund illustrates that while BABs may have introduced munis to new investors, they are basically old hat to the institutions that construct municipal investment vehicles.
Standard & Poor’s, Moody’s Investors Service, and Fitch Ratings use the same ratings scale for tax-exempt bonds and BABs, and issuers often offer the same prospectus for deals with both taxable and tax-exempt components.
“In our view, there really aren’t any,” Thomas Weyl, director of municipal research at Eaton Vance, responded when asked about the differences between researching BABs and researching tax-exempt bonds. “These are the all the credits we’re already following. ... The fact that they’re a taxable product at a different yield level doesn’t make that much of a difference.”
Whether talking about a mutual fund, exchange-traded fund, or unit investment trust, a recurring theme emerges when the sponsors of these vehicles discuss the product — a pre-existing expertise in municipals enabled them to bring their product to market.
An estimated $1.9 billion of BABs is held in vehicles like UITs, ETFs, or mutual funds.
The great majority of them are in products launched or advised by mainstays of the municipal buy-side: Van Kampen Investments, Eaton Vance, Invesco, Nuveen Investments.
Perhaps surprisingly, the earliest and biggest type of vehicle to enter the market for BABs is the unit investment trust.
Three companies — Van Kampen, First Trust Advisors, and Advisors Asset Management — have launched UITs for BAB, and all three have more pending.
Van Kampen is far and away the leader, having launched more than 30 UITs with $1.47 billion in BABs.
First Trust has launched more than $100 million in BAB unit investment trusts, and AAM has launched $80 million.
A UIT is a portfolio of bonds or some other asset in which investors buy shares. The shareholder is entitled to dividends from the income generated by the portfolio. When the bonds in mature, the proceeds are paid to shareholders and the fund shuts down.
UITs are the dominant form of BAB vehicle even though they command a relatively small share of the vehicles investing in tax-exempt municipals.
According to the Investment Company Institute, UITs hold just $9.9 billion in municipals, compared with $463.7 billion in mutual funds and $77.9 billion in closed-end funds.
It only took Advisors Asset Management a couple of months after the introduction of the BAB program to launch the first BAB trust, in May 2009.
Though the target audience is a bit different, Richard Stewart, UIT product manager at AAM, said the creation process for the BAB UITs is essentially the same as the process for tax-exempt portfolios.
For its BAB funds, AAM uses the same product construction team and the same portfolio consultant — SMC Fixed Income Management.
The only reason AAM needed to wait until May, Stewart said, was to ensure there would be enough bonds available in the market to enable a diversified portfolio.
One benefit of a UIT for BABs is that it has no ongoing need to buy new bonds for its portfolio because it is naturally self-liquidating.
In theory, a mutual fund or an ETF typically exists in perpetuity — a potential problem for a vehicle dedicated to a product slated to sunset two years after it was introduced.
While BABs are now widely expected to be extended in some form, the mutual funds and ETFs devoted to them needed an escape hatch should the program fizzle.
The Eaton Vance fund’s prospectus allows it to convert to a taxable fixed-income fund should BABs go extinct. Invesco Powershares’ $203 million BAB ETF has a similar provision — though its task is a little trickier.
By prospectus, the fund’s mission is to track an index — the Bank of America Merrill Lynch Build America Bond Index. The fund seeks to achieve this through a process known as representative sampling.
Phil Fang runs this fund, as well as Invesco’s four other muni ETFs. He said the process is no different for BABs or tax-exempt bonds. First, break the index down by risk category, including call risk, duration, credit risk, maturity, and other factors. Then construct the portfolio with bonds that reflect the aggregate risk characteristics of the overall index.
“It’s really not that much different,” Fang said. “How we manage this fund is basically the same methodology as how we manage all our municipal ETFs. ... That’s one of the reasons we said, 'Hey we can be the first in the market to have a BAB ETF.’ We already had the resources available to us.”
Fang believes being first to the market with a BAB ETF comes with certain advantages, not the least of which was securing the ticker symbol “BAB.”
If anything, he said it’s a little easier for the BAB fund to replicate its index because three of Invesco’s other funds are for insured bonds.
Because of the dearth of new issuance of insured debt, the product is more difficult to find.
A milestone moment for BAB vehicles came in February, when a Canadian firm called Connor, Clark & Lunn Capital Markets launched a BAB mutual fund, raising about $30 million. The fund is sub-advised by Nuveen Investments.
The Canadian mutual fund format is a little closer to what Americans call a closed-end fund, with the ability to borrow money and employ leverage.
Though the firm raised less than it expected, the fund was the first glimpse of the foreign buyers that taxable municipal bonds supposedly appeal to.
The foreign interest in BABs highlights one of the transformations the product has wrought in the municipal market: while the issuers are the same, the buyers are different.
Fang said Invesco believes there will be a “big audience” for BABs in the long term. For now, people are still growing comfortable with the program and feeling out in what form it will likely be extended, he said.
“As people become more familiar with the BAB program and believe the BAB program will be extended, it will be seen as favorable alternative to other taxable fixed income,” Fang said.
