WASHINGTON – In advance of possible interest rate increases later this year, the Municipal Securities Rulemaking Board is reminding dealers that a municipal security acquired in the secondary market for less than par has "market discount" that must be disclosed to unsophisticated investors.
The MSRB issued the reminder in a regulatory notice published late Tuesday. The reminder pointed dealers to their obligations under MSRB Rule G-47 on time of trade disclosure, which requires dealers to disclose to their customers, at or prior to the time of trade, all material information known about the transactions, as well as material information about municipal securities that is reasonably accessible to the market.
The board noted that a bond's original issue discount status is required to be disclosed under Rule G-47 because an investor might sell the security a price that is inappropriately low due to tax implications. Similarly, the self-regulator said it was concerned that a bond's market discount status should be disclosed because an investor might purchase the security at too high a price in light of market discount being generally taxed as ordinary income.
The amount of the market discount is equal to the excess, if any, of the stated redemption price at maturity over the basis of the security immediately after its purchase by the investor. The MSRB said that market discount occurs when the value of a muni declines after its issue date, something that often can occur because of a rise in interest rates.
"The existence of market discount may impact an investor's decision to purchase or sell an affected bond or determination of what price to pay or accept for such a bond," the MSRB said in its notice.
"The IRS market discount rule can have significant tax implications for investors," said John Bagley, MSRB chief market structure officer. "Municipal bond interest rates have increased more than 50 basis points since November 8 and we wanted to clarify for dealers that market discount is a material fact that must be disclosed to investors at or prior to the time of trade. However, the decision to remind dealers about their time-of-trade obligations is in response to the recent increase in rates and in no way represents a prediction of the future direction of interest rates."
Federal tax law dictates that, for bonds purchased after April 30, 1993, the market discount is taxed at the investor's ordinary income tax rate instead of the capital gains rate. However, if the amount of market discount is less than one-fourth of 1% of the bond's stated redemption price multiplied by the number of complete years from the date of purchase to the date of maturity, the market discount is considered de minimis and is generally taxed as a capital gain.
Original issue discount (OID) bonds -- those that are sold at the time of issue at a price that included an original issue discount -- have market discount that is calculated differently than other bonds. The OID is the amount by which the bond's stated redemption price at maturity exceeded its public offering price at the time of its original issuance and, for a tax-exempt muni, is generally treated as tax-exempt interest. Market discount for an OID bond acquired in the secondary market occurs when the bond is bought for less than its revised or adjusted issue price.
