A direct pay subsidy bond is a type of municipal bond where the issuer receives money from another entity, such as the federal government, to help with interest payments.
Some Build America Bonds (BABs), for example, were direct pay subsidy bonds. Although the bonds were issued by state and local governments, the federal government directly paid issuers 35 percent of the interest they owed to bondholders. That is, the state or local government was only responsible for 65 percent of the interest payment from its own money; thus, for a 6 percent bond, the federal government paid 2.1 percent interest and the issuer paid the remaining 3.9 percent. With the federal subsidy for interest payments, state and local governments could issue bonds at higher, more competitive interest rates.