A new study warns retail investors that their lower coupon rate bonds could become less liquid if interest rates rise.
Those findings were released Tuesday in a Municipal Securities Rulemaking Board report.
The MSRB found that retail investors tend to purchase muni bonds with lower coupons than institutional investors. The MSRB decided to do the report last year as interest rates continued to drop, which could kick into effect a tax rule that would make lower coupon bonds less liquid.
“We want investors to understand that you should be thinking about this and if rates do come up you should be aware of how it might affect the bonds,” said John Bagley, MSRB chief market structure officer.
The MSRB has not published a report similar to this before.
Under the de minimis rule, if the amount of market discount at the time of purchase is less than one-fourth of 1% of the stated redemption price of the bond multiplied by the number of complete years from the date of purchase to the date of maturity, it would fall under de minimis. The discount would then be taxed as a capital gain rather than ordinary income.
When interest rates rise, bond prices tend to fall. The tax rule typically applies in a rising interest rate environment when bond prices fall and are offered at discounts. The rule would be in effect if the investor decides to sell before maturity.
The MSRB homed in on bonds with a 3-3.5% coupon as well as 5% from May 1 to October 31, 2019 for bonds maturing in 15 years or longer.
Over half of the retail investor purchases during the period were for muni bonds with a 3.0-3.5% coupon. Most purchases by institutional investors were for bonds with a 5% coupon. Retail investors accounted for only about 8% of the purchases of 5% coupon bonds.
With trades of 100 bonds or fewer or $100,000 or less in value, the MSRB found that retail investors bought 34% of the muni bonds with a coupon rate of 3 to 3.5%. However, in using trades of $1 million or more for institution investors, the MSRB found that investors bought 16% of those lower rated bonds.
The MSRB also found that retail investors purchased 24% of muni bonds with a 5% coupon, and institutional investors purchased 41% of those bonds.
About 59% of retail investors bought 30 year bonds at a 3 to 3.5% coupon rate, while institutional investors only bought 13% of those. For 5% coupon rate bonds, 18% of retail investors bought those at a 30 year maturity, compared to 41% of institutional investors.
There is a unique risk for buying 3% coupon bonds, compared to 5% if interest rates do go up, Bagley said. A higher interest rate would make those bonds have significant discounts, putting into effect the de minimis rule.
“Peoples’ financial positions can change, their investment objectives change, so we thought you should be aware of this just in case if at some point down the road, the individual investors want to sell these,” Bagley said. “You should be tracking this because that could make the bonds significantly less liquid and can impact what kind of price you could get for your bonds.”
Patrick Luby, a senior municipal strategist at CreditSights, said higher interest rates would have a low risk of affecting bonds with maturities of 15 years, but said those with longer maturities of 20 to 30 years could have a higher risk.
Interest rates would have to significantly increase to affect 15 year bonds, Luby said.
