Interest sensitivity of municipal bonds

1. The Interest Rate Risk of Municipal Bonds
February 24, 2014
61 Broadway New York, NY 10006 212.482.0900 www.kalotay.com

2. Challenges of Managing Munis
Today’s topic:
Gains and losses are subject to complex tax treatment
Taxes 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 harvesting
Every muni is a potential candidate
Need to determine resulting benefit and optimum time to sell
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3. Tax Considerations of Discount Munis
Gain at maturity is taxable
Taxed 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-specific
Tax paid by current holder depends on purchase date and price
Hold value can far exceed market price
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4. Taxes Depress Prices of Discount Munis
10-Year Bullets
101
10-Yr Rate 3%
100
Value (% Par)
99
98
97
96
Pre-tax
95
Market Smoothed
Buy-and-Hold
94
93
2.50
2.55
2.60
2.65
2.70
2.75
2.80
Coupon (%)
4
2.85
2.90
2.95
3.00

5. When Rates Rise Price of Muni Declines More
Than Predicted by Pre-Tax Analytics
10-Year 3% Bond
101
Pre-tax Value
100
Price
99
% Par
98
97
96
95
94
93
2.95
3.05
3.15
3.25
10-Year Rate (%)
5
3.35
3.45

6. When Rates Rise Prices Will Fall More Than Expected
Bond Buyer, March 18, 2013
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
Single-A
Par Bonds
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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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8. Ignoring Taxes
Effective Duration Underestimated
10-Year Bullets
14
13
10-Yr Rate 3%
Duration)
12
Pre-tax
11
After-tax
10
9
8
2.55
2.65
2.75
2.85
2.95
3.05
Coupon (%)
8
3.15
3.25
3.35
3.45

9. Ignoring Taxes
OAS Overestimated
3% 10-Year Bullet
160
140
10-Yr Rate 3%
120
OAS (bps)
100
80
60
After-tax
40
Pre-tax
20
0
88
90
92
94
96
Price (% par)
9
98
100

10. Callable Bonds Get Hit by a Double Whammy
When Rates Rise
Because likelihood of refunding is reduced, expected life of
bond is extended and price declines accordingly
Taxables are no exception
But steeply upward-sloping muni curve exacerbates impact
When price falls below par, taxes make matters worse
Unique to munis
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11. Rising Rates Punish Discount Callable More
Than Predicted by Pre-Tax Analytics
4% Bond 15 Years to Maturity – Callable in 5 Years
104
Pre-tax Value
102
Price
% Par
100
IR Volatility 20%
98
96
94
92
3.50
3.60
3.70
3.80
3.90
4.00
4.10
15-Year Rate (%)
11
4.20
4.30
4.40
4.50

12. Rising Rates Exacerbate Duration Extension of Callable Munis:
Longer Life
Lower Price
Higher Taxes
15 Years to Maturity – Callable in 5 Years
16
Pre-tax
15
After-tax
Effective Duration
14
15-yr rate 3.5%
5-yr rate 1.5%
13
IR Volatility 20%
12
11
10
9
8
3.00
3.20
3.40
3.60
Coupon (%)
12
3.80
4.00
4.20

13. Analytical Approach:
Overlay Taxes on Standard OAS Framework
Capital gains and losses are taxable
Treatment of callables and OID’s is particularly challenging
Investors assumed to be in the top tax bracket
Key concepts: tax-neutral ‘fair’ price and OAS
Fair 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
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14. Recap: Taxes Affect Effective Duration and OAS
Discount bonds are much more sensitive to interest rates
than reported by standard analytics systems
Unpleasant 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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15. 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
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16. Contact Info
To follow-up please contact:
Andy Kalotay
andy@kalotay.com
(212) 482 0900
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