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DNY59
Taxability of Market Gains and Losses Critical
The recent dramatic increase in interest rates has created both opportunities and risks for owners of tax-exempt municipal bonds. This is not about what opportunities there might be to buy new bonds, but rather how to view and manage your existing portfolio. There are both risks and opportunities presented today as a function of the current tax law as it applies to capital appreciation and losses when holding municipal bonds. These laws can present outstanding opportunities and also present risks that should be understood and avoided.
The Big Risks
First, let’s discuss the risk side of the situation. For the last several years we’ve been in an ongoing bull market for bonds, with interest rates being driven lower year after year. As a result, a large percentage of bonds during that time period sold at a premium, meaning that the coupon rate was greater than the yield to maturity (YTM).
With bonds, as the YTM increases the dollar value (dollar price) of the bonds decreases. This is what has been happening recently with the change in the Fed’s interest rate policies. There is an excellent article on the inverse relationship between interest rates and bond prices from the SEC that states: “A fundamental principle of bond investing is that market interest rates and bond prices generally move in opposite directions.” For investors who purchased bonds at a premium, and hopefully at a large premium, this is a good thing – but only up to a point. That point is the point at which the market price of the bond is at or approaching par (100).
The Problem With Par
As soon as the value of a bond goes below par, a whole new function of pricing comes into play that will immediately accelerate the decline in value of the bond. This has to do with the tax treatment of the capital appreciation of municipal bonds bought at a market discount. The details of the rules for tax treatment of municipal bonds bought at a market discount are a bit convoluted. The important thing to understand is that the capital appreciation of bonds bought at a market discount is, for the most part, treated as regular taxable income.
A Price Decline Below Par Accelerates Potential Loss
Anyone purchasing a discount bond will only buy that bond at a price that takes into consideration the known future tax liability on the appreciation from the purchase price to par, the maturity value. This is the after-tax yield on a discount bond.
The current highest marginal individual federal income tax rate is 37%. Since the future buyer of a bond sold is frequently unknown, it is always assumed that the price of a bond sold at a discount will take into account the future tax liability at a 37% tax rate.
Compare the Major Impact on Value
Here is an example to illustrate the point (we can get actual historical YTM information from the BondWave AA QCurve).
An AA-rated bond purchased just one year ago with an 11-year maturity at the time of purchase would have been purchased at a YTM of 1.362%. One year later, on Sept. 30, 2022, the YTM on the same bond would be 3.603%. Let’s look at two examples of bonds with different coupon rates.
| Rating | Coupon | Maturity | YTM | Dollar Price | Value | Description |
| AA | 5.00 | 11 years | 1.362 | 137.047 | $1,370.47 | Purchase Price |
| AA | 5.00 | 10 years | 1.362 | 133.903 | $1,339.03 | Tax Basis |
| AA | 5.00 | 10 years | 3.603 | 111.643 | $1,116.43 | Market Price |
|
Loss Per Bond |
$222.60 16.62% |
The first example is for an 11-year bond with a 5% coupon rate purchased at 1.362 YTM. The dollar price of this bond would have been 137.047 (in dollars that would be $1,370.47). One year later, the amortized value of that bond (the tax basis) is 133.903 ($1,339.03).
The market value of the bond at 3.603 YTM would be 111.643 ($1,116.43). The market loss would be $222.60, which is about a 17% loss.
| Rating | Coupon | Maturity | YTM | Dollar Price | Value | Description |
| AA | 1.50 | 11 years | 1.362 | 101.405 | $1,014.05 | Purchase Price |
| AA | 1.50 | 10 years | 1.362 | 101.286 | $1,012.86 | Tax Basis |
| AA | 1.50 | 10 years | 3.603 | 82.472 | $ 824.72 | Market YTM |
| AA | 1.50 | 10 years | 5.410 | 70.108 | $ 701.08 | After Tx YTM |
| Loss Per Bond | $ 311.78 30.78% |
The next example is for an 11-year bond with a 1.50% coupon rate, just about par (100), and purchased at 1.362 YTM. The purchase price of this bond would be 101.405 ($1,014.05).
One year later, the amortized value of that bond (the tax basis) is 101.286 ($1,012.86). The market value of the bond would be based on the current market YTM for AA-rated 10-year bonds, a YTM of 3.603.
However, because this bond was now selling at a price below par – a discount bond – the YTM would have to be calculated to be equivalent to a 3.603 YTM after having paid the 37% tax on the appreciation in value from the purchase price to maturity at par. The dollar value of a 10-year bond with 1.50% coupon at 3.603 YTM is 82.472 ($824.72).
When the 37% future tax liability is factored in, the bond must be priced at 70.108 ($701.08), or a YTM of 5.410. This gross YTM rate produces a 3.603 after-tax yield. In this case, the market loss would be $311.78, which is about a 30% loss ($1,012.86 – $701.08 = $311.78).
Immediate Action to Take
The action to take here is to identify any bonds currently owned that have a current market value at or around par, and then sell them and replace them with bonds at the same or greater YTM than the YTM they are sold at. This comparison must be made based on the YTM sold vs. the YTM purchased, and cannot be accurately compared any other way. This might require extending the maturity date of the new bonds purchased by one or two years to cover the transaction cost involved.
The YTM sold is determined by calculating the YTM equivalent of the bonds being sold as if they were being purchased at that dollar price. Ideally, you should be able to increase the YTM purchased to be greater than the YTM sold. This should be accomplished with bonds of the same rating and category. For example, general obligation bonds for other general obligation bonds, or essential revenue bonds for essential revenue bonds.
At this time, the most important thing is to avoid the accelerated depreciation in value that occurs when the market value of bonds owned declines below par.
Don’t Focus on the Face Value (Number of Bonds)
It is also best to replace bonds sold with bonds currently selling at a substantial premium even if you have to reduce the number of bonds or the par value of bonds owned, or add to the dollars invested. It’s important to understand that the YTM calculation is calculating the rate of return on dollars invested. This is not clearly explained by most definitions of YTM, but in fact is the case.
Correct Definition of YTM
Even though YTM is the accepted basis for comparing the relative rates of return between bonds, I have not been able to find an accurate definition of YTM. You can verify this for yourself by comparing the various definitions published by the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), or any broker-dealer that offers a definition. You will find that there is no agreement among these sources, as shown below.
The definition published by FINRA:
Yield to maturity … is the overall interest rate earned by an investor who buys a bond at the market price and holds it until maturity. Mathematically, it is the discount rate at which the sum of all future cash flows (from coupons and principal repayment) equals the price of the bond. YTM is often quoted in terms of an annual rate and may differ from the bond’s coupon rate. It assumes that coupon and principal payments are made on time. It does not require dividends to be reinvested, but computations of YTM generally make that assumption. Further, it does not consider taxes paid by the investor or brokerage costs associated with the purchase.
The definition published by the MSRB:
Yield to Maturity – The rate of return to the investor earned from payments of principal and interest, with interest compounded semi-annually at the stated yield, presuming that the security remains outstanding until the maturity date. Yield to maturity takes into account the amount of the premium or discount at the time of purchase, if any, and the time value of the investment.
An accurate definition (that I created) of YTM is as follows: Yield to maturity is the rate of return earned on each dollar invested for every interest period, or part thereof, invested, if bonds are held to maturity. More specifically, YTM does not assume the reinvestment of the coupon income (cash flow). That portion of the return on investment is treated as simple interest.
Applying the Practice – a Hypothetical Example
| Amount | Rating | Coupon | Maturity | YTM | Dollar Price | Value | Description |
| 50 | AA | 4.00 | 11 years | 1.362 | 126.864 | $63,432.00 | Purchase Price |
| 50 | AA | 4.00 | 10 years | 1.362 | 124.584 | $62,292.00 | Tax Basis |
| 50 | AA | 4.00 | 10 years | 3.603 | 103.308 | $51,654.00 | Market YTM |
| 50 | AA | 4.00 | 11 years | 3.785 | 101.919 | $50,959.50 | Market YTM |
| 50 | AA | 4.00 | 10 years | 3.785 | 101.776 | $50,888.00 | Selling Price |
| 50 | AA | 6.00 | 11 years | 3.785 | 119.778 | $59,889.00 | Alternate Swap |
| 45 | AA | 6.00 | 11 years | 3.785 | 119.778 | $53,900.10 | Alternate Swap |
For example, our hypothetical bond owner would have bought 50 AA-rated 4.00% coupon bonds with 11 years to maturity one year ago, at a YTM of 1.362. The cost was $63,432.00; one year later, the amortized value, tax basis is $62,292.00. The market yield after one year for AA 4.00% coupon bonds with 10 years to maturity is a YTM of 3.603; that is the price an investor would pay to buy an AA 4.00% coupon bond with 10 years to maturity in the market – that is the “offered” side of the market.
Unlike stocks, where there is a quoted bid and offered price publicly quoted, there is no quoted “bid” for municipal bonds when you wish to sell them. The municipal nond market is a “dealer” market, so when you contact your bond dealer/broker they will either bid on the bonds for their own account, or get bids from other dealers on your behalf.
The bid side of the market will typically be based on the current offered market price (the YTM), minus the amount the dealer wants as potential profit when they sell the bonds to another investor. There is no set amount of dollars that a dealer will want, but $10 per bond for an AA-rated 50-bond lot with a 10-year maturity would be reasonable.
In this case, we are going to assume that the investor would be willing to extend their maturity date by one year to 11 years for the bonds that are being purchased to replace the bonds sold. Selling and buying bonds in this manner is frequently referred to as a bond swap.
By looking at the market for AA 4.00% coupon bonds with an 11-year maturity, we can establish a potential YTM to apply as a selling price for the investor’s 10-year bonds. In this case, AA 4.00% coupon bonds with 11 years to maturity are priced at 3.785 YTM. When we apply that 3.785 YTM to the 10-year bonds, it results in a dollar price of 101.776.
A dealer buying the 10-year bond at a YTM of 3.785 would have a $15.32 profit per bond if they were sold at the “offered” YTM of 3.603 ($1,033.08 – $1,017.76 = $15.32). This is quite a bit more than the $10 per bond potential dealer profit mentioned earlier. Therefore, it’s reasonable to think that by swapping the investor’s 10-year bonds for 11-year bonds at the same 3.785 YTM for both blocks of bonds there would be enough potential profit for the bond dealer to make the transaction.
What Would That Look Like?
| Amount | Rating | Coupon | Maturity | YTM | Dollar Price | Value | Description |
| 50 | AA | 4.00 | 10 years | 1.362 | 124.584 | $62,292.00 | Tax Basis |
| 50 | AA | 4.00 | 10 years | 3.785 | 101.776 | $50,888.00 | Selling Price |
| Capital Loss/Tax Credit | $11,404.00 | ||||||
| 50 | AA | 4.00 | 11 years | 3.785 | 101.919 | $50,959.50 | Purchase Price |
Sell the 50 AA 4.00% coupon bonds with 10 years to maturity at 3.785 YTM (101.776) – a total sale price of $50,888.00. This results in a capital loss (tax credit) of $11,404.00 based on the amortized cost/tax basis of $62,292.00 ($62,292.00 – $50,888.00 = $11,404.00). Buy 50 AA 4.00% coupon bonds with 11 years to maturity at 3.785 YTM, dollar price of 101.919, and total purchase price of $50,959.50.
This results in a one-year extension of maturity, and an additional investment of $71.50. At the end of 10 years the investor will have received the same cash flow of $2,000.00 per year as before, and have an AA 4.00% coupon bond with one year to maturity, with an unknown market value that is likely to be very close to par.
Not the Best Choice
While the above transaction creates very positive results, in my opinion it is not the best choice. That’s because the investor ends up owning 50 AA 4.00% coupon bonds at a dollar price of 101.919, which is very close to par (100). This exposes the investor to the risk of the bonds becoming discount bonds should interest rates continue to increase.
A better choice would be to invest in AA bonds with an 11-year maturity but a bigger coupon rate, at the same or greater YTM of 3.785. These bonds would be priced at a larger premium, but because YTM is the rate of return that will be received on the dollars invested, even if the number of bonds purchased is less than the number of bonds sold, you will still receive a comparable rate of return.
A Hypothetical Example
| Amount | Rating | Coupon | Maturity | YTM | Dollar Price | Value | Description |
| 50 | AA | 4.00 | 10 years | 1.362 | 124.584 | $62,292.00 | Tax Basis |
| 50 | AA | 4.00 | 10 years | 3.785 | 101.776 | $50,888.00 | Selling Price |
| Capital Loss/Tax Credit | $11,404.00 | ||||||
| 50 | AA | 6.00 | 11 years | 3.785 | 119.778 | $59,889.00 | Purchase Price |
| 45 | AA | 6.00 | 11 years | 3.785 | 119.778 | $53,900.10 | Purchase Price |
For example, replace the 50 4.00% coupon bonds sold with 50 6.00% coupon bonds with 11 years to maturity at a 3.785 YTM at a cost of $59,889.00. The additional investment would be $9,011.00, and the annual tax-free income would increase from $2,000.00 per year (50 x 40.00 = $2,000.00) to $3,000.00 per year (50 x 60.00 = $3,000.00). At the end of 10 years, the investor would have 50 6.00% bonds with one year to maturity that most likely would be worth more than par.
Alternatively, replace the 50 4.00% coupon bonds with 45 6.00% coupon bonds with 11 years to maturity at 3.785 YTM, a cost of $53,900.10. The addition investment would be $3,012.10. The annual tax-free income would increase from $2,000.00 per year to $2,700.00 per year (45 x 60.00 = $2,700.00).
Creating a Tax Credit With No Net Loss
By executing the type of transactions described above, a capital loss will be established – thus creating a tax credit. When the funds from the sale of the bonds are reinvested at a YTM the same or greater than the YTM of the bonds sold (the YTM sold is the YTM that is the equivalent to the dollar price at which the bonds are sold), you will not have any loss of return during the original holding period. The market provides this opportunity because it prices bonds of the same rating and category/quality at about the same YTM for the same maturity date.
This is most easily seen in the example above where the 4.00% coupon bonds with 10 years to maturity were replaced with comparable 4.00% coupon bonds with 11 years to maturity. That example had the same number of bonds at maturity and exactly the same annual tax-exempt cash flow of $2000.00 per year, and established an $11,404.00 tax credit.
Taking a loss on bonds bought at a premium and sold at or above par produces a tax credit, and if the proceeds are reinvested at the same or greater YTM as the YTM equivalent of the bonds sold there will be no actual cash loss on the transaction.
A very important rule for investing in tax-exempt municipal bonds is as follows: Never buy bonds at or around par, and always sell bonds at or around par.
What About ETFs and Mutual Funds?
ETFs have become a popular vehicle for investment since their inception in the 1990s. This includes a number of ETFs that hold municipal bonds. The iShares National Muni Bond ETF (NYSEARCA:MUB) and the Vanguard Tax-Exempt Bond ETF (NYSEARCA:VTEB) are the two largest by far. There are quite a few others, and a list of them can be found here. There are also mutual funds of municipal bonds. Here is an article from “U.S. News and World Report” about them that might be useful.
I do not believe that ETFs of mutual funds are a good way of investing in municipal bonds. Doing so causes the investor to give up one of the biggest assets of owning a bond – the known future maturity date. However, if you do presently own any of these investment vehicles, it would make sense to find out what strategy the managers have to take advantage of harvesting tax losses, and verify how those losses are passed along to unitholders.
Conclusion
There is an excellent opportunity for owners of municipal bonds that were purchased at a premium to take advantage of “harvesting” market losses due to the recent major increase in interest rates. If done before year end, these tax credits can be applied in the current tax year.
Special attention should always be paid to bonds whose market price is currently at or around par. Action should be considered to sell these bonds to avoid the possibility that future market changes will cause them to become discount bonds, and be subject to an acceleration of their loss of value.
Always make sure that the YTM of bonds purchased is the same or greater than the YTM of bonds sold when doing a swap. And remember the above-mentioned rule: Never buy bonds at or around par, and always sell bonds at or around par.
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