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Red-Hot Municipal Funds

Stocks in this article: BABS BABZ BAB

NEW YORK ( TheStreet) -- ETFs that invest in Build America Bonds have been on a tear. During the past year, SPDR Nuveen Barclays Capital Build America Bond (BABS) returned 25.2%, while PIMCO Build America Bond Strategy (BABZ) returned 22.5%, according to Morningstar. In contrast, the Barclays Capital Aggregate Bond index gained 7.3%.

The Build America funds focus on high-quality municipals with long maturities. That has been a recipe for success at time when nervous investors have been fleeing to Treasuries and other safe assets. Despite their big rally, the funds remain appealing for income investors. PowerShares Build America Bond (BAB) yields 4.4%, compared to a yield of 2.58% for 30-year Treasuries.

While most municipal bonds are tax free, the Build America issues are taxable. The bonds were introduced in 2009 as part of the American Recovery and Reinvestment Act. Under the legislation, the Treasury covers 35% of the cost of a municipality's interest payments on the bonds. The aim was to support municipalities that were struggling to cope with the financial crisis. States and cities jumped to issue the bonds because they were cheaper to use than traditional tax-free issues. About $181 billion of the securities have been issued.

Among the biggest buyers of the bonds have been pensions. Conservative institutions favor the Build America issues because most come with top ratings of AA and AAA. In addition, many of the bonds come with maturities of 20 years or longer, a desirable feature for institutions that must plan for long-term obligations. Many of the bonds are particularly safe because they are general obligation bonds, which are backed by the full taxing power of issuers. Other Build America Bonds are backed by essential services such as water and sewer systems, which rarely default.

Since 2010, no new bonds have been issued. President Obama has sought to continue the program, but Republicans in Congress have blocked the legislation. Even if no more bonds are issued, the Build America ETFs should continue operating for at least the next several years. Because most of the bonds have long maturities, they will continue making interest payments. Demand for the bonds should remain strong. Many institutional investors and index funds must hold the bonds because they are included in the Barclays Capital Aggregate index, a common benchmark used by many money managers. If there are no more Build America Bonds, then the ETFs would have to alter their portfolios eventually, perhaps including broader collections of taxable municipals.

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