Interest rate sensitivity of munis is greater than you think

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Managing Munis:Taxes Present Challenges and Opportunities

September 26, 2013

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What Will Happen When Rates Rise?

1991 1996 2001 2006 20110.00

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Bloomberg GO 20yr AAABloomberg GO 10yr AAA

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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

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102

Pre-Tax Market Price

Coupon (%)

Valu

e (%

Par

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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

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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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102

Coupon (%)

Valu

e (%

Par

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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

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Purchase Price (% par)

Effic

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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)

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Contact Information

Andrew Kalotay

andy@kalotay.com

(212) 482 0900