The emergence of optionless Build America Bonds paradoxically highlights the importance of the proper valuation of the call option embedded in conventional long-term tax-exempt munis. The coupons on BABs are higher, but the federal government pays the issuers a subsidy of 35% of the interest payments. So which is the better deal?
Some commentators are comparing the after-subsidy yield on BABs to the yield of a 30-year tax-exempt bond, but this is not apples-to-apples. A long tax-exempt bond is callable at par any time after 10 years. If rates decline, the issuer can refund the bonds to capture interest rate savings. By contrast, long BAB issues to date have been bullets. Their "make-whole" call provision has no financial value; it merely allows the issuer to retire the bonds at an excessive premium to the fair price - a right invoked only under extraordinary circumstances.