Falling bond prices have put the heavy supply of municipal bonds issued during this year's low interest-rate environment at risk of falling prey to a costly tax rule.
Municipal bond prices rose to a recent high in late-September, when the Municipal Market Data 30-year, triple-A general obligation bond benchmark yield was set as low as 4.62%. Muni issuers, encouraged by falling interest rates, sold $251.2 billion in long-term bonds in the year-to-date through September, a record for the first nine months of the year, according to Thomson Financial Securities Data.
But rising interest rates in October sent bond prices back down, as the MMD 30-year GO benchmark yield rose as high as 5.08%, causing some recently issued bonds to trade at discounts. In some cases, those discounts have been large enough to disqualify the bonds from an exemption to the market discount rule under the federal tax regulations, according to Evan Rourke, first vice president of fixed-income strategy at Prudential Securities Inc.
The rule requires bondholders to pay ordinary federal income taxes on the gains they would realize on bonds that they bought at significant discounts on the secondary market when they mature at par. However, if the discount is less than one-quarter point for each full year remaining to maturity on the bond, it falls within what is known as the de minimis limit, and the accrued discount is only taxable as a capital gain. For a bond with 10 years remaining to maturity to fall outside of the de minimis limit, its price would have to fall below $97.5, which is the product of 10 times 0.25, subtracted from $100, according to Philip Fischer, municipal market strategist at Merrill Lynch & Co.
Because capital gains are federally taxed at a lower rate than ordinary income, buyers are negatively impacted by the rule, which was instituted along with the Revenue Reconciliation Act of 1993, prior to which all municipal bonds were exempt from the market discount rule. The recent rise in interest rates wasn't severe enough to throw most of the discounts at which bonds were trading over the de minimis limit, Fischer said. However, those bonds that did trade outside of the limit, or close to it, were trading at depressed prices, according to market sources.
In most cases, the discounts bonds were trading at in the secondary market that put them over the de minimis limit were corrected by a bond market rally yesterday, which sent yields on the five- and 10-year GO bonds down 12 points in afternoon trading, Fischer said.
But the recent volatility has nevertheless raised awareness of the issue among market participants.
"When the muni market is rallying and rates just continuously drop, market participants tend to forget all about the de minimis rule," said Gary Strumeyer, a managing director at BNY Capital Markets Inc. "With the recent collapse of the muni market, the whole de minimis rule is reemerging, and traders and salespeople need to get reacquainted with the tax provision."
Mutual fund managers have been avoiding bonds that represent a risk of falling outside of the limit because they don't want the market penalty for falling below de minimis to be reflected in their net asset values, which they are required to calculate daily based on current market prices. When bond prices fell in 1999, some bond funds paid dearly for bonds they owned that fell outside of the limit.
Dick Berry, a senior vice president and senior portfolio manager at AIM Management Group, has been vigilantly trying to steer the municipal bond funds he runs clear of discount bonds.
That way, "there's no NAV loss to shareholders," he said.
