As the Federal Reserve board begins its meeting today on the cost of short-term borrowing, a large segment of municipal bonds that trade at or near a market discount are suddenly unwanted by many buyers.
The change is a result of recent interest rate volatility — yields are starting to rise again after several years of relatively stable levels — and a complex tax concept called the de minimis rule.
The so-called market discount de minimis rule relates to the taxability of the interest and profit earned by holding muni bonds. And since many investors enter the market specifically because of the tax-exempt status of these bonds, the potential tax liability of certain bonds can cause a large, and widely felt, dislocation in buying patterns.
“Everyone monitors the proximity to the de minimis cut off on a bond,” said Reid Smith, a portfolio manager at the Vanguard Group. “That’s when the bond moves from a tax-exempt status to a partial taxable status.”
The point at which a bond nears the de minimis cut off is a function of its price. Among other factors, a bond’s price is affected by current interest rates — as rates rise, prices fall — the coupon and maturity of the bond, the ease at which the bond can be sold on the secondary market, or its liquidity, and the specifics of the de minimis rule as it is outlined in the tax code.
Written in 1993, the “market discount” de minimis rule — there are several similarly named provisions throughout the code — relates to any bond that is bought at a price below the threshold outlined in the code. The threshold, the de minimis, is defined as one quarter of 1% of the stated bond price multiplied by the number of full years to maturity.
If the price of the bond is outside, or cheaper than, the calculated threshold — if it is sold at a market discount — the income realized from either holding that bond until maturity, or selling it at a profit sometime later, is taxed as ordinary income. Bonds whose price is within the threshold, like the vast majority of municipal bonds, are taxed as capital gains.
For example, if an investor bought a 2017 bond on the secondary market for 99, when it was originally priced at par, it would not exceed the de minimis threshold; the difference between 99 and 100 is not more than 1/4 of 1% — in this case one point — multiplied by 10 years. In this case the de minimis cutoff would be 97.5.
Obviously, the de minimis cutoff is different for every bond. But in today’s market, bonds with coupons in the neighborhood of 4.5% or lower, with maturities out longer than 20 years are particularly susceptible to the de minimis rule.
And this vulnerability can often be the death knell for a bond, as the market tends to over-penalize them, creating a self-fulfilling condition that sends the price of the bond even lower. This even happens with bonds whose price remains within the acceptable threshold.
“With a bond that is on the cusp, if the market continues to go lower those bonds are exposed to the taxable potential payment,” Vanguard’s Smith said. “Those bonds tend to underperform dramatically because the normal, everyday participant in the muni market doesn’t want those bonds.”
And yet, for the traditional buy-and-hold investor, the de minimis cutoff remains of little concern, provided they have no intention of selling the bond before it matures. From a market perspective, however, the bond’s price is still penalized by a lack of liquidity if it was ever sold, as any potential buyers would be subject to the taxable income.
As a result, investors who are more likely to buy and sell rather than buy and hold — like those at mutual funds, arbitrage accounts, or in managed retail roles — are especially cognizant of the rule.
Most likely aware of this, issuers have sold a predominant amount of premium coupons over the last few years, in an effort to meet the discerning demand of institutional investors.
“If you were talking two years ago — and this is just a guess — [premium bonds in the new-issue market] probably would have been certainly over 80% and probably over 85% [of total volume],” said Steve Galiani, managing director for tax-exempts and fixed-income for Wells Capital Management.
The percentage has fallen a bit in the past year but remains far more than 50% of total issuance, Galiani said. The prices of bonds with premium and, to some extent, par coupons have farther to fall before nearing the cutoff.
“The premium coupons are designed to protect the bond on the downside from any de minimis implications in a bear market,” Smith said.
With the generous supply, it made sense for many funds to buy premium paper over the last few years, steering clear of the bonds that are now rapidly losing their value. Scott Cottier, a senior portfolio manager at Oppenheimer Rochester National Municipal Bond Fund, said that bonds with sub-5% coupons seldom provide enough yield, to his thinking, to compensate for the liquidity risk if the market should take a downturn, as it has in the last few weeks.
“You have less liquidity and when the market does change its temperament, from a rally to a backup, you’re really left with an Old Maid card,” Cottier said.
Some people have said that arbitrage accounts may be holding a good portion of bonds now vulnerable to de minimis exposure, and whether that’s true or not, the market may now be pricing these bonds with enough value to entice the funds into the market.
“Bonds that are currently playing with the de minimis cut-off are cheaper than they were a few weeks ago, and that does register as a potential value,” Smith said. “They can have high performance characteristics in a relatively short period of time.”
Yesterday afternoon, a block of a million New Jersey’s Tobacco Settlement Financing Corp. 4.625s of 2026 were traded at a price of 92.33, with a yield of 5.27%. The bonds were originally issued at a discount in January of this year with a price of 97.19 and a yield of 4.85%, representing a spread of 42 basis points. The de minimis threshold of these bonds is about 92.57. By comparison, the Municipal Market Data triple-A yield curve has widened by 35 basis points during the same period.
The vulnerability of these bonds, to what is the latest market risk, presents a significant buying opportunity, and may shape the market as rates continue to rise.
“There are many different ways to be aggressive in this bond market,” said Matt Fabian, a senior analyst at Municipal Market Advisors. “This is just another way.”
