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Tax-Efficient Trading of Municipal Bonds

New YorkMay 14, 2015

2

Why Explore Tax Management?

Practical: Tax-driven transactions are omnipresentAd hoc ‘tax-loss harvesting’ of retail investmentsRepurchase of high-coupon corporate debt

Analytical: The right to execute a tax-driven transaction is a ‘tax option’What is its value?Optimal time to exercise?

Munis are ideal for tax-based analysisPrice and ‘hold value’ can differ

3

Recent Corporate Debt ExchangeCan You Spot the Tax Play?

Partial Exchange OfferUp to $12.5 Billion of New Notes

Up to $3.0 Billion of New 2026 Notes5.15% Notes due 2023 (pre-launch price 114.58)

Up to $4.5 Billion of New 2048 Notes5 Series of Notes maturing 2028 – 2038 (pre-launch price range 128.78 -137.10)

Up to $5.0 Billion of New 2055 Notes6.55% Notes due 2043 (pre-launch price 133.93)

Commencement Price Determination ExpirationFeb 25, 2015, 11:00am ET Feb 25, 2015, 5:00pm ET Mar 11, 2015, 11:59pm ET

4

Analytical Challenges

Tax on gain at maturity depresses market price of discount munis

Large gain taxed as ordinary income at 40%, small gain as capital gains at 20%, loss not deductible

Risk management and tax management require robust ‘tax-integrated’ analytics Standard systems ignore taxesReported Greeks can be materially misleading (shown below)

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Tax-Integrated Analytics For Munis

Fair value: overlay taxes on OAS frameworkTax-neutral value is the PV of after-tax cashflows

Lattice-based iterative calculationTax-neutral OAS adjusts for both call option and taxes

Tax option: determine value recursivelyOption acquired upon reinvestment affects sale decision

See ‘tax efficiency’ formula below

6

Taxes Depress Prices of Discount Munis

2.50 2.55 2.60 2.65 2.70 2.75 2.80 2.85 2.90 2.95 3.0090

92

94

96

98

100

102 10-Year Bullets

Pre-taxMarket SmoothedBuy-and-Hold

Coupon (%)

Valu

e (%

Par

)

10-Yr Rate 3%

2.55 2.65 2.75 2.85 2.95 3.05 3.15 3.25 3.35 3.458

9

10

11

12

13

1410-Year Bullets

Pre-taxAfter-tax

Coupon (%)

Dura

tion)

Ignoring Taxes Effective Duration Underestimated

10-Yr Rate 3%

7

Price > 100 Price < 100

8

Ignoring TaxesCredit Spread Overestimated

88 90 92 94 96 98 1000

20

40

60

80

100

120

140

1603% 10-Year Bullet

After-taxPre-tax

Price (% par)

OAS

(bps

)

10-Yr Benchmark Rate 3%

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After-Tax Proceeds from Sale

Tax treatment depends on investor’s tax basisAbove-par purchase: premium amortized to maturity or callBelow-par purchase: remains at purchase price

Gain can have split treatmentGain or loss can be short-term or long-term

Short-term rate 40%, long-term rate 20%Losses need offsetting gains; otherwise carry forward

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Unmanaged ‘Hold Value’ is Critical to Sale Decision

It is holder-specificTax at maturity depends on purchase date and purchase price

Not directly observableDiscount rates estimated from market price using tax-neutral OAS

Hold value and market price can divergeMarket price depends on tax considerations of the new buyer

11

Market Price and Hold Value Can Diverge 10-Year Bullets

2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.1091

92

93

94

95

96

97

98

99

100

101

Hold Value Given Above-Par Purchase Price

Market Price

Hold Value Given Purchase at 90

Coupon (%)

Valu

e (%

Par

)

10-Yr Rate 3%

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Sale Decision Is a Two-Step Process

1. Is it beneficial?Excess of after-tax proceeds from sale over hold value

Independent of reinvestment; like bond maintains risk exposureIn practice, tax-driven sales are presented to retail clients as ‘swaps’ – an unnecessary source of confusion

2. Do it now or wait?Timing decision depends on reinvestment strategy

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Introducing the Tax Option

The right to execute tax-driven salesAcquired automatically, at no cost, upon purchase But only astute managers know how to ‘monetize’ it

Value depends on reinvestment strategy Dynamic tax management (as below) or one-time sale

Under dynamic management reinvest in like securityTo maintain duration/risk exposure

Other considerations affecting value of tax option: Availability of short-term gains Interest rate volatility and transaction cost

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Tax Efficiency Signals When to Sell

𝑇𝑎𝑥 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦=h𝐶𝑎𝑠 𝑓𝑙𝑜𝑤 𝐵𝑒𝑛𝑒𝑓𝑖𝑡∗

𝑁𝑒𝑡 𝐿𝑜𝑠𝑠𝑜𝑓 𝑇𝑎𝑥𝑂𝑝𝑡𝑖𝑜𝑛𝑉𝑎𝑙𝑢𝑒*After-tax Proceeds from Sale – Hold Value

Maximum 100%Decision depends on risk tolerance

See demo at http://analytics.kalotay.com/munisignal/Examples follow

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Identifying Opportunities to Boost Performance

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Alternative Definitions of After-Tax ValueNeeded for After-Tax Performance

Market Value

Liquidation Value

Hold Value Used below; basis for duration calculation

Hold Value + Intrinsic Value of Tax Option

Hold Value + Value of Tax Option

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After-Tax Return for 20-Year 3.25% Par Bond Held 1 Year – 1 Day

-100

-90 -80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

ManagedUnmanaged

Yield Curve Shift (bps)

Retu

rn

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Sample After-Tax Return Calculation3.25% 20-Yr Par Bond Held for 1 Year – 1 Day

Components of Return

Starting Value 100.000

Coupon/Reinvestment Income/Ending Accrued 3.27

Sale Price 91.623

Loss = - 8.377

Tax Benefit = x 40% 3.351

After-tax Proceeds = + 94.974

Ending Value=+ 98.244

Return =/-1 -1.76%

Exceeds Unmanaged Value

of 93.455

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After-Tax Return for 20-NCL 3.25% Par Bond Held 1 Year + 1 Day

-100

-90 -80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100-15%

-10%

-5%

0%

5%

10%

15%

20%

25%ManagedUnmanaged

Yield Curve Shift (bps)

Retu

rn

20

After-Tax Return for 20-NCL 5% BondHeld 1 Year – 1 Day

-100

-90 -80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100-10%

-5%

0%

5%

10%

15%

20%

Managed

Unmanaged

Yield Curve Shift (bps)

Retu

rn

21

After-Tax Return for 20-NCL 5% BondHeld 1 Year + 1 Day

-100

-90 -80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100-10%

-5%

0%

5%

10%

15%

20%

ManagedUnmanaged

Yield Curve Shift (bps)

Retu

rn

22

Tax-Driven Sales Improve Expected Return* Par Bonds of Various Maturities – Held 1 Year - 1 Day

12 14 16 18 20 22 24 26 28 301.0

1.5

2.0

2.5

3.0

3.5

4.0

UnmanagedManaged

Maturity (yrs)

Expe

cted

Ret

urn

(%)

Short-term losses @ 40%

*Based on simulated rate scenarios using Black-Karasinski process @15% vol. Transaction cost 0.25% par.

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Performance* Boost From Tax ManagementOffsetting Short-Term Gains Available (Held 1 Year – 1 Day)

12 14 16 18 20 22 24 26 28 300.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

5% NC-10

5% NC-L

Par NC-L

Maturity (yrs)

Expe

cted

Incr

emen

tal R

etur

n (%

)

Short-term losses @ 40%

*Based on simulated rate scenarios using Black-Karasinski process @15% vol. Transaction cost 0.25% par.

24

Performance* Boost Reduced If Short-Term Losses Offset Against Long-Term Gains (1-Year Horizon)

12 14 16 18 20 22 24 26 28 300.0

0.1

0.2

0.3

0.4

0.5

0.6

0.7

5% NC-105% NC-LPar NC-L

Maturity (yrs)

Expe

cted

Incr

emen

tal R

etur

n (%

)

Short-term losses @ 20%

*Based on simulated rate scenarios using Black-Karasinski process @15% vol. Transaction cost 0.25% par.

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Setting Up For Success: Buy Premium BondsOptimizing Portfolio of 10-Year Target Duration

Bond Purchase Price

Hold Value Duration

(Yrs)

Tax Option Value (% par)

Short-Term Losses Offset

Short-Term Gains

Short-Term Losses Offset

Long-Term Gains

5% 13-year NC-L 120.83 10.04 2.91 1.17

5% 20-year NC-10 116.18 10.04 2.90 1.32

3.05% 12-year NC-L 100.00 10.15 0.79 0.00

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Tax Option Value is a Good PredictorOf Tax-Managed Performance

Bond Purchase Price

One-Year Expected Returns (%)

Buy and Hold

Tax-Managed

Short-Term Loss @ 40%

Short-Term Loss @ 20%

5% 13-year NC-L 120.83 1.95 2.78 2.30

5% 20-year NC-10 116.18 2.14 2.90 2.46

3.05% 12-year NC-L 100.00 1.96 2.32 1.96

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Recap: Tax-Driven Sales Enhance Performance

Value of tax option under dynamic management is significant; tax efficiency signals when to sell

Expected increase in annual return of intermediate-duration portfolio is 30 to 80 bps Premium bonds are best poised to achieve superior return

“It's important and surprising that the concepts described are not common knowledge at this late state of the investment game”

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Tax Management of Munis in Practice

Although potential benefit is considerable, opportunities are mostly ignored

Managers of SMA’s are reluctant to advise on taxesFor individuals, transaction cost is prohibitive

Mutual funds and ETF’s focus on pretax performanceInvestors are responsible for taxes on capital gains

Banks and insurance companies are more concerned with regulatory and accounting matters than tax-driven trades

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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” Journal of Portfolio Management, (Winter 2015)

“Tax-Efficient Trading of Municipal Bonds” (Working paper)“Optimal Municipal Bond Portfolios for Dynamic Tax Management ” (Working paper)“How to Take a Tax Loss and Then Profit From Obamacare”, Bond Buyer, (December 11, 2013)“”Premium Debt Swaps: The Best of Both Worlds?”, Financial Management (Autumn 1998)