Pricing Municipal Securities Factoring the De Minimis Rule

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1 Pricing Municipal Securities Factoring the De Minimis Rule The low interest rate environment has incentivized new investors to evaluate and enter the municipal market. However, determining the relative price of bonds is not always a simple task. Clearly there are common factors that are used to assign a bond price. They include security, sector, risk maturity, yield, state of issuance and expected liquidity. In addition, there is another factor that is not often understood and easily overlooked. This is known as the de minimis rule. This issue can trigger additional tax consequence and thereby reduce the price of a bond in the secondary market. I. Article Purpose This article defines the de minimis rule and illustrates how the valuation of a bond can be affected in the case in which the de minimis rule is involved. MUNICIPAL SALES AND TRADING April 22, 2013 Yaffa Rattner Head of Municipal Research Yaffa.S.Rattner@pjc.com Al Cappelli Municipal Credit Analyst Alphonse.X.Cappelli@pjc.com Mark Cantrell Head of Secondary Trading Mark.A.Cantrell@pjc.com Howard Manning Head of High Yield Secondary Trading Howard.K.Manning@pjc.com Jon Faison Municipal Credit Support Jonathan.A.Faison@pjc.com II. De Minimis Rule Generally, the accrued market discount on a municipal bond is treated as ordinary income when the bond is purchased or redeemed. The exception is the bond with a small discount, defined by the de minimis rule. The exception could allow an investor to pay less in taxes, so it is helpful to understand when it applies. Market discounts on municipal bonds acquired after April 30, 1993, are taxed as ordinary income rather than capital gains when the bonds mature or are sold. (It is not necessary to recognize the market discount accretion annually for tax purposes.) This law is intended to prevent taxpayers from converting ordinary income to capital gains. It also makes the tax treatment of municipal bonds consistent with taxable bonds; market discounts on most taxable bonds have been treated as ordinary income since Piper Jaffray Fixed Income Analytic Services 1

2 BONDS HELD UNTIL MATURITY The de minimis rule says that if a discount is less than 0.25 percent of the face value of a bond for each full year from the time of purchase to maturity, then it is too small to be a market discount for tax purposes. It is then treated as a capital gain, which has a lower tax rate. For example, a 10 year bond is bought at $980 giving it a $20 discount (face value of $1,000). The de minimis threshold for this bond is computed by multiplying the face value of the bond by 0.25 percent (.0025) times the number of years to maturity. For this bond the de minimis threshold would be calculated using the following equation: $1,000 (face value of the bond) x.0025 x 10 (years to maturity) = $25 (de minimis threshold) The discount of $20 is less than the de minimis threshold of $25, so the capital gains rate would be applied. If an investor purchases the bonds and holds them to maturity, they can also be affected if the market environment changes. This is because the pricing services may value the discount and the capital gains taxes associated with a de minimis rule into the pricing. While this does not cause the debt service or tax obligation to change if the investor continues to hold the bond until maturity, it can change the valuation of the security. BONDS SOLD BEFORE MATURITY There is another dimension to the tax consequences of market discount bonds for those that are sold before maturity. If a bond is sold before maturity, the selling price will determine whether capital gains or losses exist. When interest rates rise, the price of a bond will typically decline. In the case of a secondary market purchase, the bonds will be purchased at a discount to allow for the new investor to earn a market return. For example, a bond with 10 years to maturity is purchased at a price of $970 and sold after five years. Since the bond falls outside of the de minimis zone the Piper Jaffray Fixed Income Analytic Services 2

3 market discount will be subject to ordinary income tax. To determine the tax burden the investor must calculate the accreted value of the market discount on the bond and apply their marginal income tax rate to this value. (Accreted value is the theoretical price a bond would sell at if market interest rates were to remain at current levels.) In this case, the accreted value of the market discount is $150 or the discount value of the bond ($1,000 $970 = $300) divided by the term to maturity and then multiplied by the number of years the security was held by the investor. In this example, the accreted value would be computed by dividing the discount value by the term to maturity and multiplying that figure by the number of years the bond was held by the investor. $300 (discount value)/ 10 (term to maturity) = $30 x 5 (years held by the investor) = $150 Therefore, if this particular bond is sold for a price less than or equal to $985 ($970 + $15) any gain is taxed at the investor s individual income tax rate. If the bond is sold above $985 the gain is taxed at the capital gains tax rate. The gain from $970 $985 would be taxed as ordinary income and the gain above $985 would be taxed as capital gains. AFTER TAX YIELD Once the de minimis threshold is crossed, the investor s ordinary income tax rate becomes a factor in determining the valuation of the bonds. Since no one can be certain what tax rates will be in the future, convention is generally to calculate the after tax yield on the bond using the highest marginal tax rate, producing the most conservative result. Tax reporting requirements vary for different types of corporate investors, so they must evaluate how the market discount rules affect their particular situation when making investment decisions. If the investor s ordinary income and capital gains tax rates are the same, the primary disadvantage to the investor in purchasing a market discount bond is that gains classified as ordinary income cannot be used to offset capital losses. If market discount bonds are priced relatively cheap to compensate for a general tax disadvantage, they could represent value for tax indifferent investors. Piper Jaffray Fixed Income Analytic Services 3

4 In today s environment many bonds are purchased at a premium. The chart below shows that as rates change, and the bonds approach the de minimis zone, the value of the bonds is adversely affected. 10yr Bond Price Change Market Yield -5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% 5.5% 6.0% -10% Price Change % -15% -20% -18% -20% 3% Cpn Bond 4% Cpn Bond 5% Cpn Bond -25% -24% -30% Source: Piper Jaffray CONCLUSION Pricing municipal securities in the primary and secondary markets involves many factors including sector, risk assessment, maturity and current yield. However, in order to determine the tax implications of a purchase, and therefore the true net revenue of a security in the primary market or in the secondary market it is important to consider the impact of the de minimis rule. Piper Jaffray Fixed Income Analytic Services 4

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