interest rate sensitivity of munis is greater than you think
TRANSCRIPT
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Managing Munis:Taxes Present Challenges and Opportunities
September 26, 2013
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What Will Happen When Rates Rise?
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Bloomberg GO 20yr AAABloomberg GO 10yr AAA
Yiel
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Outline
The bad news: taxes depress prices of discount munisWhen rates rise, performance suffers unduly
The good news: strategic selling enhances after-tax returnHow to determine savings?What is the right time to sell?
Closing observationsReported vs. actual performance
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Investors Punish Low Coupon Bonds
… buyers demanded an additional 40 basis points for 4% coupon bonds, industry analysts estimated, … [and] … they demandedan additional 80 basis points for 3% coupons [relative to 5% bonds].
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Discount Bonds Get Hit Harder
Lower coupon bonds were hit the hardest in the recent selloff as prices declined much faster than premium bonds …
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When Rates Rise Prices Will Fall More Than ExpectedBond Buyer, March 18, 2013
Single-APar Bonds
Rates Rise 100bps
Standard Approach Kalotay Approach Δ
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
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Tax Treatment of Tax-exempt Bonds Held to Maturity – Simple Version
* 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)
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%
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OAS Framework Extended toAfter-tax Analysis of Munis
Capital gains and losses are taxableAssume investors are in the highest tax bracketKey concepts: after-tax fair price and after-tax OASFair price defined as value of after-tax cashflows, including tax payable at maturityAfter-tax valuation tools are essential for managing interest rate risk and maximizing after-tax performance
Examples below generated by MuniOAS™(patent pending)
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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 30Rate (%) 1.0 1.5 2.0 3.0 4.0 4.5
Interest Rate Volatility
20%
Transaction Cost
0.50% par
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Taxes Depress Prices of Discounts 10-Year Bullets
2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.1090
92
94
96
98
100
102
Pre-Tax Market Price
Coupon (%)
Valu
e (%
Par
)
10-Yr Rate 3%
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Ignoring Taxes Duration Underestimated10-Year Bullets
2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.48
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After-taxPre-tax
Coupon (%)
Dura
tion
(yrs
) 10-Yr Rate 3%
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Ignoring Taxes Overstated OAS
88 90 92 94 96 98 1000
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1603% 10-Year Bullet
After-taxPre-tax
Price (% par)
OAS
(bps
)
10-Yr Rate 3%
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Tax Management Opportunities
Selling losers (aka tax-loss harvesting)Short-term loss @ 40% can be very valuableSelling winners: bonds purchased at a deep discount whose value has surgedConvert part of the price appreciation from ordinary income into long-term capital gain
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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 basisObtained by OAS-based valuation
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Market Price and Hold Value Can Differ Greatly 10-Year Bullets
2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.1090
92
94
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100
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Coupon (%)
Valu
e (%
Par
)
10-Yr Rate 3%
─ Hold Value Given Above-Par Purchase Price─ Market Price
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Selling Losers
2.50% Bond – 10 Years to Maturity
Purchase Price (2 years ago) 111.85Holder’s Basis 110.00Sale Price 93.23Tax Savings 3.35After-tax Proceeds from Sale 96.58Hold Value 95.57Net Value of Transaction 1.01
All values in percent of par
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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 basisObtained 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)
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Short-Term Loss Aids Tax Efficiency
119 120 121 122 123 124-20
0
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Purchase Price (% par)
Effic
ienc
y (%
)
5% bond, 10 years remaining Purchased 6 months ago at prices shownCurrent sale price 117.20
10-Yr Rate 3%Transaction Cost 0.5%
IR Volatility 20%
Wait
Sell
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Unique Challenges of Managing Munis
Interest is tax-exemptBut gains and losses are subject to complex tax treatment that affects market price and hold valuePerformance of funds is reported pre-taxBut investors are liable for taxes due to salesActive tax managers, using correct analytics, can achieve superior after-tax performance over passive investorsBut standard analytical systems lack critical after-tax capabilities
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Hot off the Press
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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)