Tax-Smart Management of Your Muni Portfolio

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In “The True Value of Your Muni Portfolio,” I considered alternative ways of quantifying the investor-specific value of a taxable portfolio. The market value is not suitable, because liquidating the portfolio would have tax consequences, and therefore the liquidation value would be different from the market value. Instead of the market value, I recommended the “tax-smart” value, which is the greater of the security’s after-tax sale price and hold value.

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Let’s calculate the tax-smart value of a 10-year 5% bond purchased two years ago at the price of 113.3, whose current tax basis is 111. Today, with eight years remaining to maturity, the market price is 106. Sale at 106 would produce a 5-point long-term capital loss and therefore a 1-point tax saving at a 20% tax rate, resulting in after-tax proceeds from sale of 107. This exceeds the 106 hold value, and therefore today the tax-smart value is 107.

Should you sell this bond at 106 and realize the 5-point loss, or should you continue holding it?

There are two investment strategies: sell and reinvest, or do nothing. In case of a sale, the after-tax proceeds are reinvested in a like 5% 8-year bond, thus the par amount of your holding would increase by a factor 107/106.

Let’s calculate the tax-smart performance of the two strategies one year later, under two scenarios. What if rates decline and the price increases from 106 to 110? What if the price drops to 102?

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The tax-smart portfolio values corresponding to the two strategies are shown in the accompanying tables. Note that the tax basis depends on the strategy: Under the do-nothing strategy, based on the original 113.3 purchase price, it is 109.782. Under the sell and repurchase at 106 strategy, it is 105.352, and the notional amount of the investment has increased by a factor 107/106. The tax-smart returns, as measured by IRR, depend on the terminal tax-smart portfolio values and the coupon interest received during the year.


Scenario 1: Price Rises to 110 in Year 3

Year 2 Tax-Smart Value ($M) Strategy In Year 2 Year 3 Market Value ($M) Year 3 Basis ($M) Year 3 Tax-Smart Value ($M) Adjusted Semiannual Coupon ($M) Year 3 Return (%)
107.0 Sell/Reinvest 111.038 106.346 111.038 2.524 8.414
107.0 Do Nothing 110.000 109.782 110.000 2.500 7.426

If the price increases to 110, the return based on sale in Year 2 is 8.414%, and without sale it is 7.426%. The roughly 1% difference is due to the opportunity cost of not recognizing the capital loss at the end of Year 2 — once the price increases, such opportunity may be lost forever.


Scenario 2: Price Falls to 102 in Year 3

Year 2 Tax-Smart Value ($M) Strategy in Year 2 Year 3 Market Value ($M) Year 3 Basis ($M) Year 3 Tax-Smart Value ($M) Adjusted Semiannual Coupon ($M) Year 3 Return (%)
107.0 Sell/Reinvest 102.962 106.346 103.639 2.524 1.589
107.0 Do Nothing 102.000 109.782 103.556 2.500 1.466

If the price declines to 102, the performance of the tax-loss selling strategy is still slightly better: 1.589% vs. 1.466%. The difference is partly attributable to the greater interest income from reinvestment under the tax-loss selling strategy, and it also depends on the amortization of the basis corresponding to different purchase prices.

Realizing a loss and reinvesting has an additional benefit: It restarts the short-term clock. Long-term losses are deductible at 20%. Short-term losses, or those incurred in less than one year, can be deducted at the much higher rate of 40%, provided that there are offsetting short-term gains. Assuming such is the case, if the market price declines to 102, the 3.384 loss (106.346-102.962) would result in 1.354 tax savings. The tax-smart terminal value would increase to 104.316, and the return to 2.223%, from 1.589%.

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In summary, tax-smart portfolio valuation signals opportunities to improve after-tax performance by recognizing losses. It pinpoints selling opportunities by comparing after-tax proceeds from sale to hold value. Sale and reinvestment is particularly effective if the price subsequently improves, due to the opportunity cost associated with staying idle. If the price subsequently declines, restarting the short-term clock provides an opportunity to recognize short-term losses at a high effective tax rate, further improving performance relative to doing nothing.

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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Andrew Kalotay

Andrew Kalotay is a leading authority on the valuation and management of municipal bonds. His recent focus has been on maximizing the after-tax performance of separately managed accounts by dynamic investment and sales strategies. His firm’s fixed-income analytics are used by major asset managers and risk-management platforms. Before establishing Andrew Kalotay Associates in 1990, Kalotay was with Salomon Brothers. Prior to Wall Street, he was at Bell Laboratories and AT&T. On the academic side, he was the founding director of the graduate financial engineering program at Polytechnic University (now part of New York University). He is a co-author of the CFA Level II reading, Fixed-Income Analysis. Kalotay holds a BS and MS degree from Queen’s University and a PhD from the University of Toronto, all in mathematics. He was inducted into the Fixed-Income Analyst Society’s “Hall of Fame” in 1997.

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