Municipal Bond Forum

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Q

I am an FMS client and am happy with our relationship. Three questions: First: Since I obtain most of my income from municipal bonds, I end up in a low tax bracket. For example, my portfolio has an average yield of 5%. Suppose I’m in the 20% tax bracket. Therefore, my taxable bond equivalent, as I understand it, is 6.25%. If I were, instead, to be invested in taxable paper, would my tax bracket go up? Second: If I buy a 15-year bond at 103, keep it to maturity and redeem it at par, I may not deduct the difference as a long-term loss, correct? Effectively, the taxing authorities are saying that the premium simply affected the yield. Is that right? My third question is the other side of the same coin: If I buy a 15-year bond at 97 and keep it to maturity, do I pick up the difference as a capital gain? Effectively, then, the taxing authority is saying that the discount on the bond is not simply affecting the yield. If my assumptions are correct, then they are really having their cake and eating it, too. OK, while we’re discussing fairness, let me slip in a fourth question: Bond issuers often specify call dates. I guess that’s fair since we buyers go into a particular issue with our eyes open. (Why don’t we band together and tell the issuers that we want certain give-back dates at specified prices?) But, what about those “extraordinary” call provisions? How can we guard against those?

A

James A. Klotz responds:

Your questions reflect an excellent understanding of municipal bonds and the related tax implications.

You are correct in thinking that your municipal bonds would provide a higher taxable equivalent yield if you were to increase your taxable income by adding some taxable bonds to your portfolio. Keep in mind, however, that you will be trying to hit a moving target that will be affected by the trading relationship of the taxable and tax-free markets. When comparing offerings, calculate the after-tax yield on the taxable bond to be sure it nets more than the municipal. (In your bracket you will net 80% of the taxable bond yield.) As you start to add taxable bonds to the mix, you must also keep an eye on your tax bracket, which will creep up and alter the equation. You must adjust your calculations accordingly.

You answered your own questions accurately regarding the tax treatment of premium and discount bonds. The IRS does not allow the investor to declare a capital loss on premium bonds that mature at 100. But there is a capital gains tax due on the appreciation of a bond purchased at a discount.

Almost all revenue bonds are issued with some sort of “catastrophic,” “condemnation” or “extraordinary” call provision, but these calls are rarely exercised and the criteria are fairly stringent.

Take solace in the fact that bond investors have influenced issuers and underwriters over the years by resisting issues that provide little or no call protection. This is why 10 years has become the standard provision.