Volume 12, Number 1, First Quarter 2014
We explore the effect of taxes on the prices of municipal bonds. Although interest is tax-exempt, the gain resulting from purchasing a muni at a deep discount below the so-called de minimis threshold is subject to severe tax treatment. The gain is taxed as ordinary income at maturity; currently for a typical investor the applicable rate is roughly 40%. Thus, purchasing a bond at 80 would trigger an 8-point tax liability.
The paper develops a rigorous approach to the pricing of munis by incorporating taxes into the industry-standard OAS-based valuation framework. The key concept is tax-neutral value, which is simply the fair value that takes into account potential tax payments. Tax-neutral valuation allows us to explore how muni prices respond to changing interest rates. The basic insight is that due to the interaction of the purchase price and the related tax payment, discount tax-exempt bonds are significantly more sensitive to interest rates than taxable bonds. For example, currently the duration of a 10-year taxable bond is roughly 8.5 years, while that of a 10-year muni can exceed 13 years.
Tax-neutral valuation provides the foundation for accurately projecting the prices of munis under various interest rate scenarios. The primary application of this approach is risk management, including hedging. It is also essential for determining the optimum time to recognize a loss in order to maximize after-tax performance.