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Paul Fennell
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I have worked in finance and capital markets since starting with Salomon Brothers in the 1980’s, and my clients have ranged from Fortune 100 companies to Internet entrepreneurs. Currently I'm seeking institutional acceptance for a patent-pending financing structure designed as a replacement for... More
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  • The Muni Tax Swap You Can't See 0 comments
    Dec 20, 2013 2:14 PM

    What may surprise some people is that the taxability of muni bonds -- in particular the differing tax effect between holders -- presents an opportunity to capture value. That opportunity is for a bondholder, in effect, to swap his tax treatment by selling his bond, and thereby benefit from a new buyer's more favorable tax treatment. However, it's an opportunity you'd likely never see with standard fixed-income tools.

    Taxes on Municipal Bonds

    While interest on a municipal bond is tax exempt, gain on a discount purchase is taxable. Generally speaking, a portion of this discount is recorded as "accrued market discount" each year. When a bond is sold or redeemed, that AMD is recognized as ordinary income. With a top marginal rate as high as 43.4% (including the 3.8% Medicare tax), the prospect of recognizing ordinary income is clearly a negative for investors, and you can see its effects in the bond's downward price action.

    The De Minimis Cushion:

    There is a small reprieve due to the "de minimis" rule. Certain small discounts, which vary according to the remaining term of the bond, are not accrued. So if you buy a bond that has a de minimis discount, your entire gain is treated as a capital gain. That is still a tax that depresses value, but it's potentially much less than what would be owed if treated as ordinary income. These de minimis amounts are small, and as an example would be 2 1/2 points for a 10-year bond.

    The bottom line is, if you purchase a bond at a price below the de minimis threshold, that entire discount is subject to accrual. A bond bought at 91 would have 9 points of AMD recognized as ordinary income if the bond were held to maturity.

    The Opportunity

    Two investors who hold the exact same bond can have vastly different tax treatments depending on their purchase prices. For example, one who bought at a premium would owe no taxes at maturity, while another who bought at a discount would recognize AMD as ordinary income at maturity. This even though the two bondholders are otherwise identical taxpayers.

    If we assume that market participants agree on the value of the bond's cash flows, then a difference in tax treatment implies a difference in value between holders. It also means that a sale of a bond can be seen as the exercise of an option to capture that difference in tax value.

    This spells opportunity: if my bond is worth more to a new buyer because of his more favorable tax treatment, then a sale can generate value. That incremental value simply has to exceed transfer costs.

    Assessing The Basic Savings

    You could verify that a sale transaction generates savings by comparing the adjusted sales proceeds to the value of holding the bond. In the case where a holder was selling at a loss, those adjusted proceeds would equal sales proceeds less transaction costs, plus the after-tax value of the loss deduction. In the case of a gain, it would be less taxes owed.

    That analysis would be exactly comparable to calculating the savings of a mortgage refinancing, if you assumed keeping the current mortgage was the alternative to selling now.

    Missing Option Value

    The problem with that basic assessment is that you're in effect selling an option that could be exercised at any time from now until maturity (or earlier redemption). But that simple calculation gives the value of an identical option, except one that expires now. It means that while you may be capturing savings, you may not be capturing sufficient value.

    You can see this from a common sense point of view with a refinancing. If you received a mortgage 6 months ago, and rates have fallen such that you can save a few hundred dollars on your monthly payment, should you refinance now? Probably not, because the likelihood is that you'll be able to refinance later at a better rate.

    An Unseen Pure Value Play

    There can be many reasons to sell a muni bond position. An investment manager might sell based on a market call, or based on an reassessment of an issuer's credit profile, among other things.

    But unlike a refinancing -- where the potential value is obvious to investors -- the potential value in a muni bond's virtual tax option is unseen. You wouldn't know about it.

    But if you did know about it, that would be worthwhile, because capturing tax value would be as close as you can get to a pure value play.

    Expert Advice:

    My former Salomon Brothers colleague Andy Kalotay provides high-end bond analytics to institutional bond managers. His firm creates the kind of fixed income tools that would otherwise be proprietary to trading desks at the largest investment banks. (And the ideas I've presented here, those originated with Andy.)

    Andy first wrote about the concept of "refunding efficiency" over 20 years ago, and in fact I believe he originated the phrase. It calculates how much of the value of a refinancing option is captured by doing a transaction now. If a transaction captures sufficient value, the recommendation is to refinance. Otherwise the recommendation is to wait.

    Andy has adapted this technology to the 'sell' decision on municipal bonds. If you're a bond professional, it may be worth your while to explore.

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