A fund devoted to investing in Build America Bonds would have a tough time avoiding debt backed by the states of California and Illinois altogether. Eaton Vance is doing its best.

The Boston-based money manager in November launched what remains the only mutual fund dedicated to BABs, the taxable municipal securities created under the American Recovery and Reinvestment Act last year.

At the end of June, the $27.2 million Build America Bond Fund held roughly $288,000 of California general obligation debt. It owned no Illinois GOs.

This represents a substantial short position in these states relative to the fund's benchmark, the Barclays Capital U.S. Aggregate Local Authorities Index.

According to Barclays, 16.3% of the index is GO debt from one of those two states - 9% from California and 7.3% from Illinois.

The fund's combined state GO holdings from California and Illinois constitute less than 1% of its portfolio.

The severe underweighting of these credits in the fund represents an implicit bet that the benchmark index will suffer from its exposure to California and Illinois, and can be beaten simply by paring holdings from those states.

Craig Brandon, co-portfolio manager of the fund, said he expects spreads on these states' BABs to widen out as they grapple with heavy budget deficits and dysfunctional political processes.

California's budget, which sports a $19 billion hole, is on track to set a record for tardiness, and the state's controller has said he may have to issue IOUs to various types of creditors for the second consecutive year.

"The state has a lot of wood to chop to solve their problems," Brandon said. "I think that the problems will eventually peak, and I don't think we've seen the peak of the problems yet. ... I don't see them close to any solution."

Regarding Illinois: "I really don't like what's going on in Illinois."

To a lesser extent, the fund is also short issuers within these states generally.

Municipalities in California and Illinois have issued $36.8 billion of BABs, or 27.4% of the $134.5 billion of total BABs that have been issued, according to data from Bloomberg LP.

The fund's holdings of bonds from issuers in California and Illinois total 11.9% of its portfolio.

Brandon foresees very little likelihood either state will default. Rather, his concern is that spreads will bleed out and not only hurt prices but offer a better opportunity to buy later.

He pointed out that because the taxable bond market is populated with investors with little experience with or knowledge of municipals, BAB spreads have been volatile.

Inexperienced investors tend to buy these bonds and then sell at the first hint of trouble, he said, meaning exposure to a risky state's bonds can leave a fund susceptible to headline risk.

The biggest BAB Cusip - a $3 billion portion of a $6.35 billion California GO deal floated in April 2009 - caught fire in March.

The 30-year bond's yield spread over the 30-year Treasury, which was around 300 basis points at the end of February, contracted roughly 80 basis points in less than two months, based on trades reported through the Municipal Securities Rulemaking Board.

When the European sovereign debt crisis percolated, the fun ended even more abruptly than it began. California's spread spiked right back to the 300 level in less than a month.

"We always suspected there might be volatility in this market because of the new group of entrants," Brandon said. "It's people that really didn't understand the municipal market."

Brandon believes Eaton Vance's expertise with municipal securities gives the fund a leg up in avoiding pitfalls that less experienced investors might stumble into.

Cynthia Clemson, who co-manages the BABs fund with Brandon, also manages Eaton Vance's $199 million tax-exempt California fund.

According to its semiannual report, the inclination toward higher-quality issuers helped the BABs fund trounce its benchmark index in its first six months. The fund's Class C shares returned 6.2% from inception through the end of April - doubling the returns of its benchmark index.

The fund claimed the reason it did so well was its position in safer bonds, which "rallied more strongly" than riskier credits in that period in the taxable market.

Since then, shielding a BAB fund from California continues to be rewarding, trade records from the MSRB show.

Since April 30, the spread of a Wells Fargo index tracking the average BAB yield over the 30-year Treasury has widened by 45 basis points.

The spread of the biggest California BAB Cusip has widened 60 basis points.

At the end of June, the Eaton Vance fund held 88% of its portfolio in bonds rated double-A or better.

California is rated A-minus by Standard & Poor's and Fitch Ratings, and A1 by Moody's Investors Service.

Standard & Poor's rates Illinois A-plus, Moody's rates it A1, and Fitch rates it A.

The only Illinois issuers the fund owned at the end of June were two general obligation bonds from Chicago - one from the city and one from the Chicago Water Reclamation District.

The fund's biggest holdings are the New Jersey Transportation Trust Fund Authority, the Metropolitan St. Louis Sewer District, and New York City.

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