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61 Broadway New York, NY 10006 212.482.0900 www.kalotay.com
The Interest Rate Risk of Municipal Bonds:Challenges and Opportunities
November 18, 2013
2
Topics
Why taxes depress prices of discount munisWhen rates rise, performance suffers undulyBut ‘hold value’ can exceed market price
How strategic selling can enhance after-tax returnHow to determine savings?What is the right time to sell?
3
What Will Happen When Rates Rise?
1991 1996 2001 2006 20110.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
8.00
Bloomberg GO 20yr AAABloomberg GO 10yr AAA
Yiel
d (%
)
4
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
5
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].
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 …
7
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%
8
Robust OAS Technology Provides the Foundation for Rigorous Analysis
Calibrate Tree
Value Security
Yield Curve and Volatility
Security Specification
Option-adjusted Spread (OAS)
Price
Handbook of Municipal Finance (2008)
9
OAS Framework Extended to Munis
Capital gains and losses are taxableInvestors assumed to be 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 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)
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 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%
-5 5 15 25 35 4591
92
93
94
95
96
97
98
99
100
101
Pre-TaxMarket Price
Yield Curve Shift (bps)
Valu
e (%
Par
)
12
Interest Rate Sensitivity of 10-Year 3% Bond
Current price 100
13
Ignoring Taxes Duration Underestimated10-Year Bullets
2.0 2.2 2.4 2.6 2.8 3.0 3.2 3.48
9
10
11
12
13
14
After-taxPre-tax
Coupon (%)
Dura
tion
(yrs
) 10-Yr Rate 3%
14
After-Tax Duration of 30NC-10 Bonds
3.5 3.7 3.9 4.1 4.3 4.5 4.7 4.9 5.1 5.3 5.512
13
14
15
16
17
18
19
Coupon (%)
Dura
tion
(yrs
)
30-Yr Rate 4.5%IR Volatility 20%
15
Option-Adjusted Spread Measures Credit Risk
Expressed relative to a risk-free benchmark curveWhat is good benchmark curve for munis?Identifies mispriced bonds High OAS signals that bond is cheapUsed in quantifying interest rate riskCalculate prices given yield curves, keeping OAS constant
16
Recent AAA 5% NC-10 Curve
0 5 10 15 20 25 300.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
Maturity (yrs)
YTC
(%)
17
Optionless Par CurvesDerived from 5% NC-10 Curve
0 5 10 15 20 25 300.0
0.5
1.0
1.5
2.0
2.5
3.0
3.5
4.0
4.5
5.0
10% Vol 15% Vol 20% Vol
Maturity (yrs)
YTM
(%)
18
Ignoring Taxes OAS 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 Rate 3%
19
Tax Management Opportunities
Familiar transaction: selling losers*Known as tax-loss harvestingShort-term loss @ 40% can be very valuableSelling winners (bonds whose value has surged) can also be beneficial at timesRead paper, if interested
*For bonds purchased at a premium, loss is based on accreted basis
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 basisObtained by OAS-based valuation
21
Market Price and ‘Hold Value’ Can Diverge 10-Year Bullets
2.40 2.50 2.60 2.70 2.80 2.90 3.00 3.1090
92
94
96
98
100
102
Coupon (%)
Valu
e (%
Par
)
10-Yr Rate 3%
─ Hold Value Given Above-Par Purchase Price─ Market Price
22
Selling LosersBond Purchased at a Premium, Sold Below Par
2.50% Bond – 10 Years to MaturityPurchase Price (2 years ago) 111.85Holder’s Basis 110.00Sale Price 93.23
Tax Savings 3.35After-tax Proceeds from Sale 96.58Hold Value 95.57
Net Value of Transaction 1.01
All values in percent of par
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 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)
24
Benefit from Selling Increases at Higher RatesBond Purchased at Premium, Sold Above Par
-75 -50 -25 0 25 50 75 100-1.0
-0.5
0.0
0.5
1.0
1.5
2.0
2.5
3.0
Yield Curve Shift (bps)
Net
Val
ue o
f Sel
ling
(% p
ar) Current bid
price 117.20
5% bond, 10 years to maturity Purchased 2 years ago at 125.78Current tax basis 122.00
25
Interest Rate Volatility Increases Value of Tax OptionGreater Potential for Tax-Loss Harvesting
0 5 10 15 201.0
1.1
1.2
1.3
1.4
1.5
Interest Rate Volatility (%)
Tax
Opt
ion
Valu
e (%
par
)
5% bond, 10 years to maturity Purchased 2 years ago at 125.78Current bid price 117.20
26
Tax Efficiency Signals When to Sell
Net value of sale should capture most of the tax option valueDecision depends on risk tolerance; recommended minimum 90%
𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦=𝐴𝑓𝑡𝑒𝑟𝑡𝑎𝑥 𝑃𝑟𝑜𝑐𝑒𝑒𝑑𝑠−𝐻𝑜𝑙𝑑𝑉𝑎𝑙𝑢𝑒
𝑇𝑎𝑥𝑂𝑝𝑡𝑖𝑜𝑛𝑉𝑎𝑙𝑢𝑒
27
Short-Term Loss Aids Tax Efficiency
119 120 121 122 123 124-20
0
20
40
60
80
100
Purchase Price (% par)
Effic
ienc
y (%
)
5% bond, 10 years remaining Purchased 6 months ago at prices shownCurrent bid price 117.20
10-Yr Rate 3%Transaction Cost 0.5%
IR Volatility 20%
Wait
Sell
28
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 managers should be able to outperform passive investors on an after-tax basisBut standard systems lack critical after-tax capabilities
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)
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