The following analysis is based on “Tax-Smart Portfolio Valuation and Performance Measurement,” Andrew Kalotay’s forthcoming article in the Journal of Portfolio Management, and Kalotay’s “Tax-Efficient Trading of Municipal Bonds,” from the Financial Analysts Journal.
Say you have a portfolio composed of two tax-exempt municipal bonds. How do you determine its value?
|Par Amount||Coupon||Time to Maturity||Purchase Date||Purchase Price||Current Basis||Current Price|
|$100,000||5%||Eight years||Two Years Ago||113.3||111.0||106.0|
|$100,000||2%||Eight years||Two Years Ago||100.0||100.0||95.0|
If you liquidated the portfolio, the proceeds would be $201,000. But these bonds are in a taxable account — munis shouldn’t be held in an IRA — and selling has tax consequences.
The current tax basis of the 5% bond purchased for 113.3 is 111. Selling for 106 would result in a long-term $5,000 capital loss. At the applicable 20% tax rate, selling would reduce your taxes by $1,000. Therefore, to you the true worth of the 5% munis is $107,000.
Let’s apply the same analysis to the 2% bond. A sale at 95 would result in a $5,000 loss and a $1,000 tax savings. Therefore, on an after-tax basis, the 2% munis are worth at least $96,000 to you.
But discount munis are more complicated, because the so-called de minimis tax effect must be taken into account. De minimis refers to the tax treatment of the discount. The gain on a large “non-de-minimis” discount is taxed at maturity as ordinary income, at roughly 40%.
For the 2% bonds, a buyer at 95 would have a 2 point tax liability on the 5 point gain. On a present value basis, 2 points eight years from now are worth 1.7 points today. And this future tax cost is manifested in today’s 95 price — without it, the 2%s would be worth 1.7 points more, or 96.7!
The buyer of the 2% munis at 95 is being fairly compensated for the future tax cost. But how much are these bonds worth to you, considering that you bought them at par?
Because your tax basis is 100, you don’t pay tax when the 2% bonds mature, and therefore the present value of your cash flows is 96.7. This exceeds the after-tax sales price of 96 by 0.7 points! In dollar terms, the hold value of your 2% munis is $96,700. Because the hold value exceeds the after-tax proceeds from the sale, it would be a blunder to sell just to save on taxes.
In summary, the true worth of your portfolio is $107,000 + $96,700 = $203,700, which exceeds the $201,000 market value by $2,700. The takeaway is that on an after-tax basis, the value of a portfolio may be very different from its reported value. Selling at a loss may be beneficial, but be careful with discount munis: You may save on taxes but not enough to compensate you for the higher value of holding. The goal is to maximize after-tax value, rather than to save on taxes.
Viewing your muni portfolio through a tax-smart lens will open your eyes to its true after-tax value.
If you liked this post, don’t forget to subscribe to the Enterprising Investor.
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.
Image credit: ©Getty Images / PaytonVanGorp
Professional Learning for CFA Institute Members
CFA Institute members are empowered to self-determine and self-report professional learning (PL) credits earned, including content on Enterprising Investor. Members can record credits easily using their online PL tracker.
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.