Tax-Efficient Trading of Municipal Bonds

The author proposes a dynamic strategy to optimize the after-tax performance of a municipal bond portfolio. This study extends previous work on one-time tax-loss selling. He considers a potential tax-driven trading opportunity as an option with quantifiable value, acquired automatically and without cost in a taxable account. Within this formulation, selling a bond and reinvesting in another also entails the swap of the associated tax options. When considering the value of the tax option acquired upon reinvestment, the time to optimum execution is drastically reduced in comparison to one-time selling. The author assumes that the choice of reinvestment bonds maintains the same interest rate exposure as that from before the sale.The summary was prepared by Jennie I. Sanders, CFA, New York City.What’s Inside?Municipal bonds (munis) held in taxable accounts provide a unique opportunity for tax-driven divesting because the realized capital gains and losses present a taxable event, contrary to the interest that is tax exempt. By ignoring the tax option acquired by selling a muni and reinvesting the proceeds into a similar bond, a one-time sale may miss subsequent opportunities to improve after-tax performance. In contrast, dynamic management, which involves selling a muni and then reinvesting the proceeds into a similar muni, has the potential to create more value by swapping into a new option and extending the time value. Such a strategy could increase the after-tax return by 30–100 bps annually depending on the duration of the portfolio and the investor’s tax situation.How Is This Research Useful to Practitioners?Because of trade size constraints and transaction costs, this research is intended for holdings in a separately managed account. In a one-time sale, the benefit of selling consists entirely of cash flow savings, which are equal to the difference between the after-tax proceeds from the sale of the muni and the hold value, in which the hold value is the worth of the muni to its holder. Thus, investors have to wait for the price of a muni to drop sufficiently to realize a large enough cash flow savings to justify the sale. In contrast, under a dynamic strategy, the benefit of selling includes two components: cash flow savings as well as the value of the new option acquired by reinvesting the proceeds from the sale of the muni into another muni. Thus, the sale of a muni can be executed sooner (i.e., at a smaller cash flow savings) under dynamic management compared with a one-time sale because reinvestment of the proceeds from the sale provides additional free optionality, whose value can be incorporated into the dynamic strategy to maximize after-tax performance.This research expands on previous work that explored the tax-neutral approach, the optimal time to sell without considering how the proceeds are reinvested, and the value added by active tax management compared with buy-and-hold investing.How Did the Author Conduct This Research?The author considers four strategies: buy and hold, sell now (if beneficial), one-time sale, and dynamic management. He defines the key concepts of after-tax valuation of munis, such as the tax basis, liquidation value, hold value, cash flow benefit from selling, and tax option. The tax option is acquired automatically and without cost upon the purchase of a muni, and its value depends on both investor-specific information and market data, such as the price volatility of the muni and transaction costs.The author notes that the tax option value depends on the management strategy. For the buy-and-hold strategy, the option value is worthless. For the sell-now strategy, the option value is equal to the intrinsic value. The distinction between the one-time sale and dynamic management strategies is the role of the option acquired upon reinvestment of the proceeds from the sale of the muni into another muni. Reinvestment is a potential enhancer of performance.The author illustrates how selling a muni at par purchased a year before at par and then purchasing a similar muni at a slightly higher price could add additional value by writing off a loss at the short-term capital gains tax rate, which is significantly higher than the long-term capital gains tax rate. The value of the tax option embedded in a muni increases as the price of the muni drops and as volatility rises. The incentive to sell the muni increases as its price drops. Regarding the dynamic strategy, volatility and the price of the muni to be sold are not the major factors affecting the sale decision. Instead, the sale decision is driven by the time value of the tax option embedded in the new muni in which the proceeds of the old muni will be reinvested as well as by the cash flow savings. For the purpose of his illustrations, the author assumes that interest rates evolve consistent with the Black–Karasinski process with a modest mean-reversion factor as well as the abundance of 5% coupon munis callable at par any time after 10 years. The 5% callable curve must be converted into an optionless par curve for valuation purposes by using a stochastic model for interest rates as described in Kalotay and Dorigan (Journal of Fixed Income 2009). The author also assumes that the effective duration is constant (i.e., that the interest rate risk of the portfolio stays the same after the tax-driven trade). Otherwise, there would be an incentive to increase the tax optionality by extending duration.Abstractor’s ViewpointThis research is helpful in educating investors about the additional opportunities presented by munis. For many investors, munis are attractive instruments for inclusion in taxable accounts because of their tax-exempt interest. But investors may overlook the opportunity they also present for tax-loss harvesting and the advantage of reinvesting the proceeds from selling munis to preserve the embedded tax option. Although it is common to think of equities in taxable accounts as candidates for tax-loss harvesting, investors may be biased by a buy-and-hold mentality regarding munis when making tax-related decisions. This research offers them an additional tool for tax-efficient portfolio management.Editor’s note: The author may have a commercial interest in the topics discussed in this article.Editor’s note: This article was reviewed and accepted by Executive Editor Robert Litterman.Author’s note: The methods discussed in this article are patent pending.