Why De Minimis Risk Is a Topic Again

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The increase in interest rates since November has brought with it a heightened awareness of the tax implications facing retail investors who favor discount paper, municipal experts said this week.

The de minimis exception allows for some relief from the Market Discount Rule by permitting a discount of less than 0.25% of face value times the number of each full year between the bond's acquisition date and its maturity date to be treated as a capital gain. Thus, if de minimis comes into play, the capital gains tax rate would apply, rather than the higher rate, if taxed as ordinary income.

For instance, if a bond is purchased at a discount which is less than a quarter point per year, the lower capital gains rate applies. If the discount equals or exceeds that de minimnus amount - more than a quarter point per year -- the gain realized at maturity is taxed at the higher ordinary income rate, which is 39.6% for top bracket taxpayers.

While there is no immediate de minimis risk for the broader municipal market, the uptick in interest rates has put a spotlight on the tax ramifications of discount bonds, analysts said.

"De minimis is an issue for certain low-coupon bonds more so in the retail space that favors lower dollar/low-coupon price structures," Peter Block, managing director at Ramirez & Co., said this week.

Block said based on the firm's recent research, rates would have to rise 200 basis points on average across the curve for 25% of the market to be priced outside of de minimis.

For example, if rates rose 202 basis points, 27% of the market be at risk of trading in de minimis territory, according to Block's research.

Ramirez used the Merrill Muni Master Index to gauge its prediction, because this index has over 23,000 Cusips that represent the broad market. "Different portfolios with various durations will react quite differently," he said.

In addition, a rate increase of 275 basis points would cause 50% of the broader market to be subject to de minimis risk. Even if rates rose only 100 basis points, the percentage of the market trading in de minimis would be 11%, according to Block.

Retail tends to hold the lower-coupon and lower-priced bonds that can be subject to the de minimis threshold compared with institutional investors who prefer higher coupons, such as 5% premium bonds, that face less de minimis risk, experts noted.

When rising rates drive prices lower, more bonds become subject to a tax penalty, as appreciation from the discounted price can be treated as a capital gain or even regular income.

If a bond falls to de minimis, the rule is that appreciation is taxed at a capital gains rate; and if it falls at a discount that pushes through de minimis it's then taxed as ordinary income.

"Institutional investors are more aware of the issue, and often rotate out of bonds selling near the de minimis price point, replacing with a higher coupon bond, typically selling at a premium price," Alan Schankel, managing director at Janney Capital Markets explained.

Concerns over de minimis risk could pick up steam later this year, though at the first Federal Open Market Committee meeting Wednesday the Federal Reserve Board chose not to raise rates and kept the fed funds target rate to between 0.50% and 0.75%.

It's been a while since retail investors have had to worry about being subject to de minimis risk, according to Schankel.

"Many retail investors are unaware or have forgotten about the potentially costly impact of purchasing bonds at prices below the de minimis break point," he said in an interview.

Select retail investors started to monitor their holdings a little more closely in the fourth quarter than they had in recent years, when rates were unchanged and there was little or no de minimis risk, municipal analysts said.

"Towards the end of 2016, we did see some retail investors swapping out of lower-coupon bonds that took losses due to the bond rout, in order to incur tax losses to offset capital gains elsewhere and/or buy different bonds – some with higher coupons – also known as tax swaps," Block said. "This has slowed down considerably in January."

Schankel, in a December report, wrote that years of falling interest rates "left most municipal bonds trading at or above par, so market discount concerns faded to rear view mirror status."

But with the Fed still in a tightening stance – and with a new administration in the White House and income tax season approaching – investors are on guard for potential de minimis risk within their holdings.

"We haven't seen anything on the tax front from Congress or Trump yet, but we are on high alert," Block said.

The lower-priced, lower coupon paper could be subject to the tax treatment under the de minimis threshold should rates climb higher at the next or subsequent Federal Reserve Board meetings.

The Fed has indicated its intention to raise rates two to three times in 2017 – possibly beginning with the June meeting, market participants said.

Bonds can trade at an amount below par equal to one-fourth of 1% of the principal amount of the bond multiplied by the number of full years until the bond's maturity. To remain above de minimis, a bondholder can't get more than a quarter point of appreciation per year of holding the bond.

An investor who bought par bonds close to par when rates were low, and is facing de minimis, must reflect the additional tax implications when trying to sell them.

A rate increase of 25 basis points on Dec. 14 heightened awareness about the de minimis risk among investors.

After the rate action, the yield on the 10-year benchmark muni general obligation was unchanged from 2.37% the prior day, while the yield on the 30-year dropped two basis points to 3.16%, according to the final read of Municipal Market Data's triple-A scale.

"The sharp, post-election jump in tax free yields revives taxation issues for municipal bond investors related to market discount treatment of municipal bonds and the value of the de minimis exception, which may impact investors purchasing bonds at prices below par value," Schankel wrote.

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