When De Minimis Kicks In, Muni Analytics Come Up Short

January 31, 2017

Getting Risk Right for Discount Munis

by Michael Palmieri

Municipal bond yields are on the rise. Between July and December of last year, the 10-year AAA rate was up over 100 bps. As the volume of munis selling at a discount increases, so does the attention paid to the long dormant De Minimis Tax Rule, which determines the tax treatment of such bonds. A small (de minimis) discount is taxed as a capital gain at maturity (currently 23.8% for high brackets). Large discounts are taxed as ordinary income (43.4%).

Highlighting the de minimis tax rule, a recent MSRB regulatory notice emphasized that material information on municipal bonds bearing market discounts must be disclosed to customers. Asset managers are alerting clients through updated guidelines on their websites; see PIMCO’s Understanding the De Minimis Tax Rule, Fidelity’s De Minimis Dilemma and Schwab’s Discount Munis: What You Need to Know About Taxes.

Discount bond prices are depressed by the tax payable at maturity; their yields are higher than those of similar premium bonds. But for portfolio managers, there is a more critical risk management issue - rising interest rates result in steeper declines in the prices of discount bonds than those of premium bonds.

While asset managers and investment advisors dutifully inform their clients of the de minimis tax treatment, the more pertinent question is: do they have the proper analytics to determine the fair price of a discount, or the effect of a yield curve shock? You won’t find this information on their websites.

One notable exception is BlackRock, who recently notified customers of the addition of “after-tax” functionality for accurately calculating OAS and effective duration. Their deployment of Kalotay Analytics’ patent-pending “tax-aware” valuation methodology was a forward-looking enhancement that will inform and protect their clients in these times of rising interest rates.

Check out the Kalotay Analytics muni risk demo for side-by-side comparisons of (misleading) conventional versus (correct) after-tax OAS analysis, using the live AP-MBIS muni yield curve as a benchmark.  See how industry leaders like BlackRock and Investortools have implemented this tax-aware MuniOAS methodology for their clients at www.kalotay.com/MuniOAS_news.