Q:  How has the Eaton Vance Build America Bond Fund evolved?

Build America Bonds are a new class of taxable bonds that investors can diversify into. The bond program was enacted into law in February 2009. The success of this program spurred Eaton Vance Management to launch the Eaton Vance Build America Bond Fund on November 17, 2009 as America's first actively managed mutual fund designed for investment in taxable municipal obligations issued under the American Recovery & Reinvestment Act of 2009.

Q:  How are Build America Bonds different from other bonds?

Build America Bonds are taxable municipal bonds that carry special tax credits and federal subsidies for either the bond issuer or the bondholder. BABs were created under Section 1531 of Title I of Division B of the American Recovery and Reinvestment Act that the U.S. President Barack Obama signed into law on February 17, 2009. The purpose of BABs is to reduce the cost of borrowing for state and local government agencies, as well as to provide issuers greater access to the capital markets by tapping a wider potential group of investors. There are two types of Build America Bonds: Tax Credit BABs and Direct Payment BABs. The Direct Payment BABs provide a federal subsidy of 35% of the interest paid on the bonds to the issuer. This programs has been responsible for the vast majority of all BABs issued to date. The Tax Credit BABs provides a federal subsidy as a refundable tax credit directly to the bondholders. While the bondholder is the recipient of the tax credit through Tax Credit BABs, and the bond issuer is the recipient of the tax subsidy through Direct Payment BABs, both options are designed to reduce the cost of borrowing for the bond issuer As intended by the program, the investors in BABs bonds have widened dramatically from the typical retail driven investor of traditional tax exempt municipal bonds. The biggest holders of BABs to date include both traditional and non-traditional municipal bond holders, as well as taxable institutional investors. These institutional investors include insurance companies, mutual funds, and various foreign investors looking to diversify credit exposure and match long liabilities. BABs, like municipal bonds, are debt securities issued by a state, city, county or other municipality to finance its capital expenditures. The bonds have a typical maturity of 10 to 30 years and are generally highly rated bonds, with approximately half of all Build America Bonds issued to date rated AA or higher. In contrast to tax-exempt bonds, the interest earned on direct pay Build America Bonds is taxable to the recipient and issuers of Build America Bonds receive a direct payment from the federal government equal to 35% of the interest paid. Build America Bonds provide investors with corporate bond-like income combined with the credit quality profile of municipal bonds, providing an opportunity to earn yields comparable to similarly rated corporate bonds, but with potentially higher credit quality. For taxable fixed income investors, Build America Bonds represent an entirely new asset class that can enhance portfolio diversification.

Q:  What is the size of the Build America Bond market?

To date, $90 billion has been raised through 1,066 bond issues in 48 states under the program since its launch last year. While the program is scheduled to expire at the end of 2010, the House of Representatives has passed a bill to extend the program for three years while the president proposed making the program permanent in his 2010-11 budget. The total cost of the program is difficult to estimate, though initial projections claim that the two-year program would cost the federal government $4.3 billion over 10 years. But state and local governments will eventually save $12.3 billion from bonds issued in the first year of the Build America Bonds program. It is anticipated that total issuance of BABs in 2010 could reach $120 billion, or 20-30% of projected municipal issuance. Build America Bond issuance in February alone was $7.2 billion.

Q:  What is the total issuance of municipal bonds in 2009?

The total issuance of municipal bonds was around $400 billion in 2009.

Q:  Why are foreign investors generally interested in the U.S. municipal bonds and in BABs?

While foreign investors have not typically been large buyers of tax-exempt municipal bonds, many foreign investors are interested in purchasing BABs. These investors are primarily purchasing BABs through vehicles such as fund or institutional accounts. On the whole, foreign investors are interested in the BABs because they represent an opportunity to diversify into a new high quality asset class while also maintaining a corporate-like income stream.

Q:  Why are states in the United States not allowed to go bankrupt?

States are not allowed to file bankruptcy. Local government or municipal bankruptcies are governed by Chapter 9 of the federal bankruptcy code. However, Chapter 9 specifically excludes states from filing under that statute.

Q:  Who monitors the financial health of states?

Most states have a constitutional provision that require the governor and legislature to enact a balanced budget either annually or biennially. There are various ways they do that. Many states have made difficult decisions to raise taxes and cut spending in order to enact a truly balanced budget. However, other states, such as California, have relied more heavily on one-time fiscal actions such as pushing payments forward into future years and not really balancing their budget on a year-to-year basis. They have also historically relied heavily on highly cyclical capital gains taxes and personal income taxes.

Q:  What is the investment strategy behind the Build America Bonds Fund?

The primary objective of the Build America Bond fund is current income, while the secondary objective is capital appreciation. Under normal market circumstances, the fund invests at least 80% of net assets in taxable municipal obligations issued pursuant to the American Recovery and Reinvestment Act of 2009 or other legislation providing for the issuance of taxable municipal debt on which the issuer receives federal support of the interest paid. The fund may also invest up to 20% of net assets in debt obligations other than Build America Bonds, including taxable municipal obligations that do not quality for federal support, U.S. Treasury securities and obligations of the U.S. Government, its agencies and instrumentalities

Q:  How do you execute your investment process?

As with all of our traditional tax-exempt municipal funds, we take a relative value approach to investing our BAB fund. This means that we look at all of the individual bonds that make up the investable universe and decide whether those bonds represent good relative value compared to other bonds in the marketplace. The Build America Bond portfolio is generally high quality since almost all of the bonds issued under the program have been issued by higher-quality issuers. However, we feel that research is a crucial component to understanding relative value, and we conduct credit research on all of the bonds that we are considering purchasing for the portfolio. Often issuers are in the market simultaneously with both traditional tax-exempt municipal bonds and BABs, we are often looking at both the tax exempt and taxable bonds that these issuers are bringing to market.

Q:  Can you walk us through some examples of bonds that you consider for investing?

We look to diversify as much as we can across different states and sectors. That being said, the very nature of the legislation which created BABs makes this asset class is more concentrated than traditional municipal market as there are only specific types of bonds that can be brought to market under the BABs program. Much of the issuance in BABs has been focused in the following sectors: General Obligation bonds, special tax bonds, public education, infrastructure and transportation. An example of the relative value process that we invest with can be seen looking at a recent issue for Arizona State University (ASU). We liked the credit characteristics of the issue, but instead of simply buying the issue because we liked the credit, we also looked other issues that were both in the primary market and the secondary market. This analysis included comparing the ASU issue with a recently issued bond for Bowling Green State University in Ohio – both in terms of credit characteristics and pricing levels. Taking the analysis one step further, we compared the ASU issue with a similarly rated water and sewer bond to determine which sector was providing the superior relative value. Other factors included in the final purchase decision included overall fund exposure to AZ bonds, to the higher education sector, and to the actual bond structure.

Q:  How do you construct the portfolio in terms of securities, the yield curve, duration management and credit quality?

Portfolio construction is a bottom-up process, which considers diversification across sectors, states and issuers. Since most of the Build America Bond issuance to date has been in the 20-year to 30-year part of the yield curve due to the cost saving to the issuers in that part of the yield curve, the portfolio has a natural weighting to long maturities. Since our portfolio construction relies on picking individual bonds rather than replicating an index we can add substantial value by selecting bonds that we think will perform well in the market-place, and those that should improve in credit quality over time. While the fund is not managed to an index, the reference index is for the Build America Bond Fund is the Local Authorities sub-index of Barclays Capital Aggregate Bond Index. The fund has been growing over the past several months, which has allowed us to continually add new positions to the fund. Since we are currently in acquisition mode, portfolio turnover is currently low. As the portfolio continues to age one would expect the turnover rate to increase.

Q:  What kind of risks do you see in the marketplace and how do you manage them?

The biggest risk right now to the BAB program is whether it will be extended past the current expiration date of 12/31/2010. The U.S. House of Representatives has put forth a bill to extend the Build America Bond program for another three years, with a reimbursement rate to the issuer that ratchets down from 35% to 30% over the three years. In addition, President Barack Obama has proposed in his budget to make the BAB program permanent. In addition, the President has proposed expanding the program to cover more of the traditional tax-exempt sectors, while lowering the subsidy rate to 28%.

Q:  What is your sell discipline?

Our sell discipline is really just the inverse of our buy discipline as we are looking at relative value. Since we are buying very high-quality bonds, the sell decision first comes down to what is the relative spread versus other bonds in the marketplace, and second, is there an opportunity to buy more attractive bonds in the new issue market versus the secondary market issue.

Q:  Are there any lessons to be learned from the macro environment of the past year?

One of the most important lessons that investors should take from the market environment in the past year is the importance of performing thorough research. We have always stressed the importance of credit research, and our research staff generates an independent rating for credits that we purchase. Having a firm grasp on the credit fundamentals is instrumental to making sound investment decisions, as well as performing relative value analyses.