Understanding true interest rate risk of munis and tax-managing muni investments

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Tax Management of Municipal Bonds
Abbreviated Version
Charleston, SC, April 18,2014

2. 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. 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. 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. 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. 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
Value(%Par)
Coupon (%)
10-Year Bullets
Pre-tax
Market Smoothed
Buy-and-Hold
10-Yr Rate 3%

7. 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. 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. 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. 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. 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
Value(%Par)
Coupon (%)
Hold Value Given Above-
Par Purchase Price
Market Price
Hold Value Given
Purchase at 90
10-Yr Rate 3%

12. 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. 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. 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. 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
NetBenefitfromSelling(%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

16. 16
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. 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
TaxOptionValue(%par)
Interest Rate Volatility (%)
5% bond, 10 years to maturity
Purchased 2 years ago at 125.78
Current bid price 117.20

18. 18
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 =
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 − 𝐻𝐻𝐻𝐻 𝑉𝑉𝑉𝑉𝑉
𝑇𝑇𝑇 𝑂𝑂𝑂𝑂𝑂𝑂 𝑉𝑉𝑉𝑉𝑉

19. 19
Short-Term Loss Enhances Tax Efficiency
-20
0
20
40
60
80
100
119 120 121 122 123 124
Efficiency(%)
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. 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. 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. 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)