NEW YORK - Wells Fargo & Co. has launched an index tracking the performance of Build America Bonds, the hottest sector in government finance.

The Wells Fargo Build America Bond Index measures total returns on big, liquid BAB issues.

To be eligible for inclusion, a BAB must have at least $100 million in par value, mature in a year or more, pay a fixed rate and not be in default.

The index currently is made up of 29 securities. The index value kicked off, retroactively to May 1, at 100, and has since climbed to about 107.

Dan Forth, head of strategic indexing for Wells Fargo, called the index a “vital step” in the evolution of BABs. The index will help educate investors, provide transparency and enable people to monitor the market, he said.

“We believe it’s an important evolution in the market, given the concern over the future funding requirements of municipal entities,” Forth said.

The index weights the included securities by market value, and determines prices from observed secondary trades combined with inputs from the Bloomberg relative value model.

The Bloomberg model ascertains what a municipal bond should trade at, based on comparisons with bonds of similar credit quality and size.

BABs were created through the American Recovery and Reinvestment Act, which President Obama signed into law in February.

In lieu of the traditional tax exemption on municipal debt, state and local governments can sell taxable bonds and collect a federal subsidy equal to 35% of the interest costs.

The program is designed to allow municipalities to float bonds to investors who do not pay taxes and thus have no reason to bid on tax-exempt paper.

Since the first BABs hit the market in April, issuers have sold $26.92 billion of the bonds, according to Bloomberg.

The pricing and liquidity of BABs is a crucial matter for local governments.

Governments that need to raise money often face a choice: sell tax-exempt bonds at one interest rate or sell taxable bonds at a rate that is nominally higher. Under the BAB program that rate is potentially lower after the federal subsidy. The more aggressively BABs price, the less cost-effective tax-exempt financing will seem.

Some have speculated the federal government created BABs as a test to see whether the municipal finance market could be viable without the tax exemption.

The pricing of BABs has therefore been of great interest to the municipal market.

Some issuers faced questions about the pricing of their deals. Some have said they agreed to pay too much interest on their debt, considering yields on some of the first BABs dropped sharply and immediately after issuance.

Many investors have compared BAB yields with yields on corporate bonds, or sovereign bonds from other countries.

Bank of America-Merrill Lynch municipal strategist Phil Fischer has created an informal BAB index, averaging the yields on some of the biggest issuers.

Total return is one of 12 attributes Wells Fargo measures with its indexes. Others include modified duration, option-adjusted spread over Treasuries, and average yield.

Six are available on Bloomberg now, under the function “BABS Index.” Forth said the other six will be available by Friday.

Forth has been creating indexes for eight years, and said he has created more than 50. His career constructing indexes began when he worked in bond origination, and constructed proprietary indexes to track the markets he was involved in.

The Build America Bonds program will sunset next year absent an extension by Congress.

If it does continue, the index can continue to develop as the number of deals eligible for inclusion grows, Forth said. He pointed out some indexes are comprised of thousands of securities.

 

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