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61 Broadway New York, NY 10006 212.482.0900 www.kalotay.com The Interest Rate Risk of Municipal Bonds February 24, 2014
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61 Broadway New York, NY 10006 212.482.0900 www.kalotay.com
The Interest Rate Risk of Municipal Bonds
February 24, 2014
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Challenges of Managing Munis
Today’s topic:
Gains and losses are subject to complex tax treatmentTaxes affect value, interest rate risk, and OAS of bonds
currently or potentially selling at a discount
Need analytics for hedging and scenario analysis
Standard systems ignore taxes when calculating effective
duration (exception: Investortools)
Topic for another day:
Active managers could achieve superior after-tax return by
strategic tax-loss harvestingEvery muni is a potential candidate
Need to determine resulting benefit and optimum time to sell
3
Tax Considerations of Discount Munis
Gain at maturity is taxableTaxed as ordinary income if purchased below de minimis
(for individuals as high as 43.4%)
Above de minimis taxed as capital gains at 23.8%
Rates above include Obamacare surcharge
Tax on gain depresses market price (see next slide)When rates rise performance based on mark-to-market suffers
unduly (corroborated by EMMA prices – see Ang, et. al.,
Journal of Finance, 2010)
However ‘hold value’ is investor-specificTax paid by current holder depends on purchase date and price
Hold value can far exceed market price
4
Taxes Depress Prices of Discount Munis
93
94
95
96
97
98
99
100
101
2.50 2.55 2.60 2.65 2.70 2.75 2.80 2.85 2.90 2.95 3.00
Val
ue
(% P
ar)
Coupon (%)
10-Year Bullets
Pre-tax
Market Smoothed
Buy-and-Hold
10-Yr Rate 3%
5
When Rates Rise Price of Muni Declines MoreThan Predicted by Pre-Tax Analytics
93
94
95
96
97
98
99
100
101
2.95 3.05 3.15 3.25 3.35 3.45
% P
ar
10-Year Rate (%)
10-Year 3% Bond
Pre-tax Value
Price
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When Rates Rise Prices Will Fall More Than ExpectedBond Buyer, March 18, 2013
Single-A
Par Bonds
Rates Rise 100bps
Standard Approach Kalotay ApproachMistake by
Standard Approach
Price Yield Price Yield PriceYield
(bps)
2-yr 0.90% 98.05 1.90 96.82 2.54 -1.23 64
5-yr 1.65% 95.35 2.65 92.84 3.21 -2.51 56
10-yr 3.00% 91.82 4.00 88.94 4.38 -2.88 38
7
Investors Punish Low Coupon Bonds
… buyers demanded an additional 40 basis points for 4% coupon bonds,
industry analysts estimated, … [and] … they demanded
an additional 80 basis points for 3% coupons [relative to 5% bonds].
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9
10
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13
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2.55 2.65 2.75 2.85 2.95 3.05 3.15 3.25 3.35 3.45
Du
rati
on
)
Coupon (%)
10-Year Bullets
Pre-tax
After-tax
Ignoring Taxes � Effective Duration Underestimated
10-Yr Rate 3%
8
9
Ignoring Taxes �OAS Overestimated
0
20
40
60
80
100
120
140
160
88 90 92 94 96 98 100
OA
S (
bp
s)
Price (% par)
3% 10-Year Bullet
After-tax
Pre-tax
10-Yr Rate 3%
10
Callable Bonds Get Hit by a Double WhammyWhen Rates Rise
Because likelihood of refunding is reduced, expected life of
bond is extended and price declines accordinglyTaxables are no exception
But steeply upward-sloping muni curve exacerbates impact
When price falls below par, taxes make matters worse Unique to munis
11
Rising Rates Punish Discount Callable More Than Predicted by Pre-Tax Analytics
92
94
96
98
100
102
104
3.50 3.60 3.70 3.80 3.90 4.00 4.10 4.20 4.30 4.40 4.50
% P
ar
15-Year Rate (%)
4% Bond 15 Years to Maturity – Callable in 5 Years
Pre-tax Value
Price
IR Volatility 20%
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9
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11
12
13
14
15
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3.00 3.20 3.40 3.60 3.80 4.00 4.20
Eff
ecti
ve D
ura
tio
n
Coupon (%)
15 Years to Maturity – Callable in 5 Years
Pre-tax
After-tax
IR Volatility 20%
15-yr rate 3.5%
5-yr rate 1.5%
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Rising Rates Exacerbate Duration Extension of Callable Munis:Longer Life � Lower Price � Higher Taxes
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Analytical Approach: Overlay Taxes on Standard OAS Framework
Capital gains and losses are taxableTreatment of callables and OID’s is particularly challenging
Investors assumed to be in the top tax bracket
Key concepts: tax-neutral ‘fair’ price and OASFair price equals the PV after-tax cashflows, including tax
payable at maturity; determined iteratively
Tax-neutral OAS adjusts for both call option and taxes
Essential for managing interest rate risk and to enhance
after-tax performance
14
Recap: Taxes Affect Effective Duration and OAS
Discount bonds are much more sensitive to interest rates
than reported by standard analytics systemsUnpleasant surprise when rates rise
Wider than normal spread for a discount bond does not
mean that bond is cheap For rigorous rich-cheap analysis use tax-neutral OAS
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References
“The Interest Rate Sensitivity of Tax-Exempt Bonds Under Tax-Neutral Valuation”
The Journal of Investment Management (First Quarter 2014)
“The Tax Option in Municipal Bonds”
The Journal of Portfolio Management (Winter 2014)
“How to Take a Tax Loss and Then Profit from Obamacare”
The Bond Buyer, December 11, 2013
“For Investors, Stress-testing Munis is Easier Said Than Done”
The Bond Buyer, March 18, 2013.
“The Allure of 5% Bonds: Coupon Levitation Creates Magical Savings”
The Bond Buyer, January 27, 2012
"Taxes on Tax-Exempt Bonds,” Ang, A., V. Bhansali, and Y. Xing,
Journal of Finance 65 (No. 2), 565-60, 2010
See kalotay.com/research
