Every week we highlight a stock or an ETF that we think makes sense in the current market. Today we break the routine slightly to discuss a new fixed income investment: Build America Bonds. You are probably unaware of these instruments unless you’re privy to a particular state or municipal project funded by them. Institutional investors have been buying in droves. So what exactly is a BAB?

Congress created the Build America Bonds just this year in the American Recovery and Reinvestment Act of 2009 – better known as President Obama’s “economic stimulus” package. These bonds are issued by state or local government agencies but pay a higher coupon rate than a typical municipal bond. Their purpose is to fund local capital projects: roads, sewers, jails, and so forth. Thanks to a federal subsidy, BABs pay a higher yield than normal muni bonds. For example, when California issued a BAB in early 2009, it offered a 7.4% interest rate to bondholders. The State of California only paid 4.8% of the issue with the US Government paying out the remaining 2.6% (35% of the total).

The other difference between a BAB and regular muni is that a BAB is taxable. They are more comparable to corporate bonds, which makes them more attractive to tax-exempt investors. Institutional investors like pension plans and foreign investors don’t pay US income tax, so they get an extra 54% return for the same bond with little added risk. With the U.S. Treasury standing behind them, Build America Bonds are essentially a form a high-yielding Treasury bond.

Demand for BABs has been heavy. The first public offering for Build America Bonds was April 2009 and by mid-September some $32.6 billion had been issued, according to Bloomberg. Since many individual investors are reluctant to buy individual bonds, financial services marketers smell an opportunity to package them into something more user-friendly. Invesco PowerShares is planning to issue a BAB ETF while Eaton Vance is working on an open-end mutual fund.

Neither of these products is available for purchase yet, but we suspect they will be very successful. Meanwhile, investors who are familiar with fixed-income securities should take a look at Build America Bonds.