Tax-Efficient Trading of Municipal Bonds
New York
May 14, 2015
61 Broadway New York, NY 10006 212.482.0900 www.kalotay.com
Why Explore Tax Management?
Practical: Tax-driven transactions are omnipresent
Ad hoc ‘tax-loss harvesting’ of retail investments
Repurchase 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 analysis
Price and ‘hold value’ can differ
2
Recent Corporate Debt Exchange
Can You Spot the Tax Play?
Partial Exchange Offer
Up to $12.5 Billion of New Notes
Up to $3.0 Billion of New 2026 Notes
5.15% Notes due 2023 (pre-launch price 114.58)
Up to $4.5 Billion of New 2048 Notes
5 Series of Notes maturing 2028 – 2038 (pre-launch price range 128.78 -137.10)
Up to $5.0 Billion of New 2055 Notes
6.55% Notes due 2043 (pre-launch price 133.93)
Commencement
Feb 25, 2015, 11:00am ET
Price Determination
Feb 25, 2015, 5:00pm ET
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Expiration
Mar 11, 2015, 11:59pm ET
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 taxes
Reported Greeks can be materially misleading (shown below)
4
Tax-Integrated Analytics For Munis
Fair value: overlay taxes on OAS framework
Tax-neutral value is the PV of after-tax cashflows
Lattice-based iterative calculation
Tax-neutral OAS adjusts for both call option and taxes
Tax option: determine value recursively
Option acquired upon reinvestment affects sale decision
See ‘tax efficiency’ formula below
5
Taxes Depress Prices of Discount Munis
10-Year Bullets
101
10-Yr Rate 3%
100
Value (% Par)
99
98
97
96
Pre-tax
Market Smoothed
Buy-and-Hold
95
94
93
2.50
2.55
2.60
2.65
2.70
2.75
2.80
Coupon (%)
6
2.85
2.90
2.95
3.00
Ignoring Taxes  Effective Duration Underestimated
10-Year Bullets
14
Price < 100
13
Price > 100
10-Yr Rate 3%
Duration)
12
Pre-tax
11
After-tax
10
9
8
2.55
2.65
2.75
2.85
2.95
3.05
Coupon (%)
7
3.15
3.25
3.35
3.45
Ignoring TaxesCredit Spread Overestimated
3% 10-Year Bullet
160
140
10-Yr Benchmark Rate 3%
120
OAS (bps)
100
80
60
After-tax
40
Pre-tax
20
0
88
90
92
94
96
Price (% par)
8
98
100
After-Tax Proceeds from Sale
Tax treatment depends on investor’s tax basis
Above-par purchase: premium amortized to maturity or call
Below-par purchase: remains at purchase price
Gain can have split treatment
Gain or loss can be short-term or long-term
Short-term rate 40%, long-term rate 20%
Losses need offsetting gains; otherwise carry forward
9
Unmanaged ‘Hold Value’ is Critical to Sale Decision
It is holder-specific
Tax at maturity depends on purchase date and purchase price
Not directly observable
Discount rates estimated from market price using tax-neutral OAS
Hold value and market price can diverge
Market price depends on tax considerations of the new buyer
10
Market Price and Hold Value Can Diverge
10-Year Bullets
101
100
10-Yr Rate 3%
99
Value (% Par)
98
97
96
95
Hold Value Given AbovePar Purchase Price
Market Price
94
93
Hold Value Given
Purchase at 90
92
91
2.40
2.50
2.60
2.70
2.80
Coupon (%)
11
2.90
3.00
3.10
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 exposure
In 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 sales
Acquired 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 security
To maintain duration/risk exposure
Other considerations affecting value of tax option:
Availability of short-term gains
Interest rate volatility and transaction cost
13
Tax Efficiency Signals When to Sell
𝐶𝑎𝑠ℎ𝑓𝑙𝑜𝑤 𝐵𝑒𝑛𝑒𝑓𝑖𝑡 ∗
𝑇𝑎𝑥 𝐸𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 =
𝑁𝑒𝑡 𝐿𝑜𝑠𝑠 𝑜𝑓 𝑇𝑎𝑥 𝑂𝑝𝑡𝑖𝑜𝑛 𝑉𝑎𝑙𝑢𝑒
*After-tax Proceeds from Sale – Hold Value
Maximum 100%
Decision depends on risk tolerance
See demo at http://analytics.kalotay.com/munisignal/
Examples follow
14
Identifying Opportunities to Boost Performance
15
Alternative Definitions of After-Tax Value
Needed 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
16
After-Tax Return for 20-Year 3.25% Par Bond
Held 1 Year – 1 Day
25%
Managed
20%
Unmanaged
15%
Return
10%
5%
0%
-5%
-10%
-15%
Yield Curve Shift (bps)
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Sample After-Tax Return Calculation
3.25% 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%
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Exceeds
Unmanaged Value
of 93.455
After-Tax Return for 20-NCL 3.25% Par Bond
Held 1 Year + 1 Day
25%
Managed
20%
Unmanaged
15%
Return
10%
5%
0%
-5%
-10%
-15%
Yield Curve Shift (bps)
19
After-Tax Return for 20-NCL 5% Bond
Held 1 Year – 1 Day
20%
Managed
15%
Unmanaged
Return
10%
5%
0%
-5%
-10%
Yield Curve Shift (bps)
20
After-Tax Return for 20-NCL 5% Bond
Held 1 Year + 1 Day
20%
Managed
15%
Unmanaged
Return
10%
5%
0%
-5%
-10%
-100 -90 -80 -70 -60 -50 -40 -30 -20 -10 0 10 20 30 40 50 60 70 80 90 100
Yield Curve Shift (bps)
21
Tax-Driven Sales Improve Expected Return*
Par Bonds of Various Maturities – Held 1 Year - 1 Day
4.0
Short-term losses @ 40%
Expected Return (%)
3.5
3.0
2.5
2.0
Unmanaged
Managed
1.5
1.0
12
14
16
18
20
22
Maturity (yrs)
24
26
28
30
22
*Based on simulated rate scenarios using Black-Karasinski process @15% vol. Transaction cost 0.25% par.
Performance* Boost From Tax Management
Offsetting Short-Term Gains Available (Held 1 Year – 1 Day)
1.6
Expected Incremental Return (%)
Short-term losses @ 40%
1.4
1.2
1.0
0.8
5% NC-10
0.6
5% NC-L
0.4
Par NC-L
0.2
12
14
16
18
20
22
Maturity (yrs)
24
26
28
30
23
*Based on simulated rate scenarios using Black-Karasinski process @15% vol. Transaction cost 0.25% par.
Performance* Boost Reduced If Short-Term Losses
Offset Against Long-Term Gains (1-Year Horizon)
0.7
Short-term losses @ 20%
Expected Incremental Return (%)
0.6
0.5
0.4
0.3
0.2
0.1
5% NC-10
5% NC-L
0.0
Par NC-L
-0.1
12
14
16
18
20
22
Maturity (yrs)
24
26
28
30
24
*Based on simulated rate scenarios using Black-Karasinski process @15% vol. Transaction cost 0.25% par.
Setting Up For Success: Buy Premium Bonds
Optimizing Portfolio of 10-Year Target Duration
Tax Option Value (% par)
Purchase
Price
Hold Value
Duration
(Yrs)
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
Bond
25
Tax Option Value is a Good Predictor
Of Tax-Managed Performance
One-Year Expected Returns (%)
Bond
Purchase
Buy and
Price
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 intermediateduration 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”
27
Tax Management of Munis in Practice
Although potential benefit is considerable, opportunities
are mostly ignored
Managers of SMA’s are reluctant to advise on taxes
For individuals, transaction cost is prohibitive
Mutual funds and ETF’s focus on pretax performance
Investors 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)
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