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Tax Management of Municipal Bonds Abbreviated Version
Charleston, SC, April 18,2014
2
Unique Challenges of Managing Munis
Bond values depend on taxes on gains and losses Standard systems ignore taxes; reported interest rate risk and credit risk measures are unreliable Theoretical bond valuation framework has been extended to include taxes
Main topic: maximizing after-tax return How to calculate benefit from selling How to decide when to sell Need after-tax analytics
3
When Rates Rise Prices Will Fall More Than Expected Bond Buyer, March 18, 2013
Single-A Par Bonds
Rates Rise 100bps
Standard Approach Kalotay Approach Mistake by Standard Approach
Price Yield Price Yield Price Yield (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
4
Taxation of Tax-Exempt Munis Held to Maturity
Gain is taxable at maturity, but loss is not deductible Large gain taxed as ordinary income Small gain (purchase above de minimis threshold) taxed as capital gains
When rates rise, tax on gain to new buyer depresses price But ‘hold value’ depends on current investor’s purchase date and price, and can differ from market price
5
Analytical Approach: Overlay Taxes on Standard OAS Framework
Incorporate taxes on capital gains and losses
Including callables and OID’s Assume investors are in the top tax bracket
Key concepts: tax-neutral value and OAS Tax-neutral value is the PV of after-tax cashflows, including tax at maturity; determined iteratively Tax-neutral OAS adjusts for both call option and taxes
6
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
Valu
e (%
Par
)
Coupon (%)
10-Year Bullets
Pre-taxMarket SmoothedBuy-and-Hold
10-Yr Rate 3%
7
After-Tax Performance Is The Right Measure
Munis are held in after-tax accounts Directly: Individual and separately managed accounts (SMA’s) Indirectly: Mutual funds and ETF’s Also: insurance companies and other financial institutions
Objective should be to achieve superior after-tax return Including taxes associated with gains and losses
Performance can be enhanced by strategic sales Tax-loss harvesting is the standard, but not the only, method
8
Tax Treatment of Gain/Loss on Sale Prior to Maturity
Depends on investor’s tax basis Purchased at a premium: amortized value Purchased at a discount: purchase price
Gain can have split treatment OIDs are complicated (not discussed)
Can be short-term or long-term For high-income individuals, short-term rate is 43.4%; long-term rate is 23.8% Losses need offsetting gains; otherwise carry forward
9
Tax Management Opportunities
Familiar transaction: selling losers Known as tax-loss harvesting Short-term loss @ 43.4% can be very valuable
Selling winners (bonds purchased at a discount whose value surged) can also be beneficial
Can you figure out why?
10
‘Hold Value’ is Critical to the Sale Decision Hold Value = PV (bond flows + tax due from current holder)
Tax is based on purchase date and price Applicable tax rate is investor-specific Discount rates estimated from trades of like bonds
Hold value and market price can diverge Market price depends on tax considerations of the new buyer It is also affected by liquidity
Bonds purchased or selling at a discount
require special attention
11
Market Price and Hold Value Can Diverge 10-Year Bullets
91
92
93
94
95
96
97
98
99
100
101
2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.10
Valu
e (%
Par
)
Coupon (%)
Hold Value Given Above-Par Purchase PriceMarket Price
Hold Value GivenPurchase at 90
10-Yr Rate 3%
12
Sale Decision Is a Two-Step Process
1. Is it beneficial? Compare after-tax proceeds from sale to hold value Benefit does not depend on the replacement bond, but reinvestment in like bond maintains risk exposure
In practice, tax-driven sales are presented to retail clients as ‘swaps’ – an unnecessary source of confusion
13
Calculation of Benefit from Selling a Loser Bond Purchased at a Premium, Sold Below Par
2.50% Bond – 10 Years to Maturity
Purchase Price (2 years ago) 111.85 Holder’s Basis 110.00 Sale Price (after 0.5% spread) 93.22 Loss = – (16.78) Tax Savings @ 23.8% 3.99 After-tax Proceeds from Sale = + 97.21 Hold Value 95.57 Net Benefit of Transaction = – 1.64 All values in percent of par
14
Sale Decision Is a Two-Step Process
1. Is it beneficial? Compare after-tax proceeds from sale to hold value
2. Do it now or wait? Sale at a later time may be more beneficial, depending on rates How to deal with interest rate uncertainty?
15
Benefit from Selling Increases as Rates Rise
-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
-75 -50 -25 0 25 50 75 100
Net B
enef
it fro
m S
ellin
g (%
par
)
Yield Curve Shift (bps)
Bond Purchased at Premium, Sold Above Par
Lower Prices
Current bid price 117.20
5% bond, 10 years to maturity Purchased 2 years ago at 125.78 Current tax basis 122.00
Higher Prices
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Introducing the Tax Option
The right to execute tax-driven trades is a tax option Every investor owns this free option But only astute managers know how to ‘monetize’ it
Value of tax option depends on volatility of interest rates Interest rates affect price, which in turn affects tax benefit
17
Volatility Increases Value of Tax Option Greater Potential for Tax-Loss Harvesting
1.0
1.1
1.2
1.3
1.4
1.5
0 5 10 15 20
Tax O
ptio
n Va
lue (
% p
ar)
Interest Rate Volatility (%)
5% bond, 10 years to maturity Purchased 2 years ago at 125.78 Current bid price 117.20
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Tax Efficiency Signals When to Sell
Benefit should realize most of forfeited tax option value Decision depends on risk tolerance; 90% minimum recommended No reason for delaying at 100%
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸 =𝐴𝐸𝐴𝐸𝐴𝐴𝐴𝐴 𝑃𝐴𝑃𝐸𝐸𝐸𝑃𝑃 −𝐻𝑃𝐻𝑃 𝑉𝐴𝐻𝑉𝐸
𝑇𝐴𝐴 𝑂𝑂𝐴𝐸𝑃𝐸 𝑉𝐴𝐻𝑉𝐸
19
Short-Term Loss Enhances Tax Efficiency
-20
0
20
40
60
80
100
119 120 121 122 123 124
Effic
iency
(%)
Purchase Price (% par)
5% bond, 10 years remaining Purchased 6 months ago at prices shown Current sale price 117.20
10-Yr Rate 3% Transaction Cost 0.5%
IR Volatility 20%
Wait
Sell
20
Summary
Munis offer opportunities for tax-driven sales Can generate positive after-tax cashflow
Tax option: right to execute such sales Its value depends on market volatility and transaction cost
Tax efficiency signals when to execute
21
Tax Management Today: Theory and Practice
Benefit can be considerable Value of tax option in new long-term muni is roughly 5 points Translates into at least 30 bps annual outperformance over ‘buy-and-hold’
But tax considerations are largely ignored by managers Mutual funds and ETF’s report only pretax performance
Investors are responsible for taxes on capital gains Managers of SMA’s are reluctant to advise on taxes For individuals, transaction cost is prohibitive
22
References “Bond Valuation in Tax Denial”, Quant Forum (March 29, 2014) “The Tax Option in Municipal Bonds,” A. Kalotay, D. Howard, Journal of Portfolio Management, (Winter 2014) “The Interest Rate Sensitivity of Tax-Exempt Bonds under Tax-Neutral Valuation,” Journal of Investment Management, (First Quarter 2014) “Optimum Tax Management of Municipal Bonds” (working paper) “How to Take a Tax Loss and Then Profit From Obamacare”, The Bond Buyer, (December 11, 2014)