This document discusses the interest rate risk of municipal bonds and opportunities for tax management. It begins by explaining how rising interest rates will negatively impact municipal bond prices more than expected due to their tax treatment. It then presents a framework for evaluating bonds on an after-tax basis using option-adjusted spreads, which properly accounts for taxes and shows how taxes depress prices of discount bonds. The document concludes by outlining a two-step process for determining when to strategically sell bonds to realize tax losses or gains, enhance after-tax returns, and maximize the value of tax options.

1. The Interest Rate Risk of Municipal Bonds:
Challenges and Opportunities
November 18, 2013
61 Broadway New York, NY 10006 212.482.0900 www.kalotay.com

2. Topics
Why taxes depress prices of discount munis
When rates rise, performance suffers unduly
But „hold value‟ can exceed market price
How strategic selling can enhance after-tax return
How to determine savings?
What is the right time to sell?
2

3. What Will Happen When Rates Rise?
8.00
7.00
6.00
Yield (%)
5.00
4.00
3.00
2.00
Bloomberg GO 20yr AAA
Bloomberg GO 10yr AAA
1.00
0.00
1991
1996
2001
3
2006
2011

4. When Rates Rise Prices Will Fall More Than Expected
Bond Buyer, March 18, 2013
Rates Rise 100bps
Single-A
Par Bonds
Standard Approach
Kalotay 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
Δ

5. 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].
5

6. Discount Bonds Get Hit Harder
Lower coupon bonds were hit the hardest in the recent selloff as prices
declined much faster than premium bonds …
6

7. Tax Treatment of Tax-exempt Bonds
Held to Maturity – Simple Version
Purchase Price
Treatment
Tax Rate*
At a premium
Premium amortized to zero
N/A
At a de minimis**
discount
Taxed as capital gain
20%
At a non-de minimis
discount
Taxed as ordinary income
40%
* Marginal tax rate implied by EMMA prices is „very high‟
** 0.25 x the number of remaining years to maturity (e.g. 2.50 for a 10-year bond)
7

8. Robust OAS Technology Provides the
Foundation for Rigorous Analysis
Yield Curve
and Volatility
Security
Specification
Calibrate Tree
Value Security
Option-adjusted
Spread (OAS)
Handbook of Municipal Finance (2008)
8
Price

9. OAS Framework Extended to Munis
Capital gains and losses are taxable
Investors assumed to be in the highest tax bracket
Key concepts: after-tax fair price and after-tax OAS
Fair price defined as value of after-tax cashflows, including tax
payable at maturity (determined iteratively)
After-tax valuation tools are essential for managing
interest rate risk and to maximize after-tax performance
Examples below generated by MuniOAS™ and MuniSignal™
(patent pending)
9

10. Assumptions for Following Exhibits
Tax Rates
Income
40%
Short-term capital gains/losses
40%
Long-term capital gains/losses
20%
Issuer Par Optionless Yield Curve
Mty (yrs)
1
2
5
10
20
30
Rate (%)
1.0
1.5
2.0
3.0
4.0
4.5
Interest Rate Volatility
Transaction Cost
20%
0.50% par
10

11. Taxes Depress Prices of Discounts
10-Year Bullets
101
10-Yr Rate 3%
100
Value (% Par)
99
98
97
96
95
Pre-Tax
Market Price
94
93
2.40
2.50
2.60
2.70
2.80
Coupon (%)
11
2.90
3.00
3.10

12. Interest Rate Sensitivity of 10-Year 3% Bond
101
Pre-Tax
100
Market Price
Value (% Par)
99
Current
price 100
98
97
96
95
94
93
-5
5
15
25
Yield Curve Shift (bps)
12
35
45

13. Ignoring Taxes  Duration Underestimated
10-Year Bullets
14
After-tax
13
Pre-tax
Duration (yrs)
12
10-Yr Rate 3%
11
10
9
8
2.0
2.2
2.4
2.6
2.8
Coupon (%)
13
3.0
3.2
3.4

14. After-Tax Duration of 30NC-10 Bonds
19
18
30-Yr Rate 4.5%
IR Volatility 20%
Duration (yrs)
17
16
15
14
13
12
3.5
4.0
4.5
Coupon (%)
14
5.0
5.5

15. Option-Adjusted Spread Measures Credit Risk
Expressed relative to a risk-free benchmark curve
What is good benchmark curve for munis?
Identifies mispriced bonds
High OAS signals that bond is cheap
Used in quantifying interest rate risk
Calculate prices given yield curves, keeping OAS constant
15

16. Recent AAA 5% NC-10 Curve
5.0
4.5
4.0
YTC (%)
3.5
3.0
2.5
2.0
1.5
1.0
0.5
0.0
0
5
10
15
Maturity (yrs)
16
20
25
30

17. Optionless Par Curves
Derived from 5% NC-10 Curve
5.0
4.5
4.0
YTM (%)
3.5
3.0
2.5
2.0
1.5
1.0
10% Vol
0.5
15% Vol
20% Vol
0.0
0
5
10
15
Maturity (yrs)
17
20
25
30

18. 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)
18
98
100

19. Tax Management Opportunities
Familiar transaction: selling losers*
Known as tax-loss harvesting
Short-term loss @ 40% can be very valuable
Selling winners (bonds whose value has surged) can also
be beneficial at times
Read paper, if interested
*For bonds purchased at a premium, loss is based on accreted basis
19

20. Sale Decision is a Two-Step Process
1. Is it profitable?
Compare after-tax proceeds from sale to „hold value‟
Hold value not directly observable
Depends on holder‟s basis
Obtained by OAS-based valuation
20

21. Market Price and „Hold Value‟ Can Diverge
10-Year Bullets
101
10-Yr Rate 3%
100
Value (% Par)
99
98
97
96
95
─
94
─
Hold Value Given
Above-Par Purchase Price
Market Price
93
2.40
2.50
2.60
2.70
2.80
Coupon (%)
21
2.90
3.00
3.10

22. Selling Losers
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
93.23
Tax Savings
3.35
After-tax Proceeds from Sale
96.58
Hold Value
95.57
Net Value of Transaction
1.01
All values in percent of par
22

23. Sale Decision is a Two-Step Process
1. Is it profitable?
Compare after-tax proceeds from sale to „hold value‟
Hold value not directly observable
Depends on holder‟s basis
Obtained by OAS-based valuation
2. Do it now or wait?
Compare value of „tax option‟ relative to savings, i.e. on the „tax
efficiency‟ of the sale
Value of tax option depends on transaction cost and interest rate
volatility (even if bond is optionless)
23

24. Benefit from Selling Increases at Higher Rates
Bond Purchased at Premium, Sold Above Par
3.0
Net Value of Selling (% par)
2.5
Current bid
price 117.20
2.0
1.5
1.0
0.5
0.0
5% bond, 10 years to maturity
Purchased 2 years ago at 125.78
Current tax basis 122.00
-0.5
-1.0
-75
-50
-25
0
25
Yield Curve Shift (bps)
24
50
75
100

25. Interest Rate Volatility Increases Value of Tax Option
Greater Potential for Tax-Loss Harvesting
Tax Option Value (% par)
1.5
1.4
1.3
1.2
5% bond, 10 years to maturity
Purchased 2 years ago at 125.78
Current bid price 117.20
1.1
1.0
0
5
10
Interest Rate Volatility (%)
25
15
20

26. Tax Efficiency Signals When to Sell
Net value of sale should capture most of the tax option value
Decision depends on risk tolerance; recommended minimum 90%
26

27. Short-Term Loss Aids Tax Efficiency
10-Yr Rate 3%
Transaction Cost 0.5%
IR Volatility 20%
100
Efficiency (%)
80
Sell
60
Wait
40
20
5% bond, 10 years remaining
Purchased 6 months ago at prices shown
Current bid price 117.20
0
-20
119
120
121
122
Purchase Price (% par)
27
123
124

28. Unique Challenges of Managing Munis
Interest is tax-exempt
But gains and losses are subject to complex tax treatment that
affects market price and hold value
Performance of funds is reported pre-tax
But investors are liable for taxes due to sales
Active managers should be able to outperform passive
investors on an after-tax basis
But standard systems lack critical after-tax capabilities
28

29. References
"Taxes on Tax-Exempt Bonds,“ A. Ang, V. Bhansali, Y. Xing, Journal of
Finance, Vol. 65, No. 2 (2010)
"Optimal Bond Trading with Personal Taxes," Constantinides, G. M. and J. E.
Ingersoll, 1984, Journal of Financial Economics, 13(No.3), 299-335.
“What Makes the Municipal Yield Curve Rise”, A. Kalotay, M. Dorigan, Journal of
Fixed Income (Winter 2008)
“The Tax Option in Municipal Bonds,” A. Kalotay, D. Howard, Journal of Portfolio
Management, (Spring 2014, forthcoming)
“The Interest Rate Sensitivity of Tax-Exempt Bonds under Tax-neutral Valuation,”
Journal of Investment Management (forthcoming)
“Optimum Tax Management of Municipal Bonds” (working paper)
29