New federal income tax law changes could hurt the performance of some tax-exempt discount bonds, analysts at several municipal firms say.
Due to currently low tax-exempt yields, most portfolio managers see little cause for concern about higher tax rates in the near term. But municipal analysts are alerting investors that the luster of discount bonds purchased and traded in the secondary market could be dulled by the prospect of greater taxable returns.
The new law, which affects the tax treatment of any municipal bond purchased at a discount in the secondary market after April 30, 1993, eliminates the exemption that tax-exempt bonds were granted from market discount rules adopted in 1984. Those rules required that such discounts be treated as ordinary income instead of capital gains.
Under the old law, gains for secondary market purchasers from original issue discount bonds or zero coupon bonds were taxed at the capital gains rate of 28%. Now some of gains will continue to be treated as capital gains, but some will also be treated as ordinary income and taxable at the applicable income tax rate, which could be as high as 39.6%.
The law does not apply to the appreciation, or accretion, on an original-issue discount bond, which is a bond issued at a price below par. The accretion, or the imputed interest gained as the bond moves toward maturity, is treated as tax-exempt. The law also does not apply to premium bonds, those purchased at a price above par.
But the changes could hurt the performance of original-issue discount, or zero coupon, bonds in a bear market, according to Michael J. Ross, a first vice president at Kemper Securities Inc. in Chicago.
Such bonds, which are highly sensitive to changes in interest rates, have greater volatility and are generally considered to be the securities of choice when interest rates are falling, Ross said in a new Kemper research report. Because the bonds do not pay a coupon, the price appreciates faster as rates fall.
However, in a bear market when municipal prices are falling and interest rates are rising, an investor who purchases the bond in the secondary market and later resells it at a premium could see some of his income taxed as ordinary income.
The securities may still be a good value for long-term, buy-and-hold investors who purchased the bonds in the primary market, the Kemper analyst said. But the prospect of taxable income could prompt investors to demand a higher return and greater discounts when purchasing market discount bonds.
"You'll want the bond to trade cheaper, to make up for the taxes you will have to pay," the Kemper analyst said.
Analysts at J.P. Morgan Securities Inc. are also pointing out the possible new tax liabilities to investors.
The law should make original-issue discount bonds purchased in the primary market more attractive than secondary market counterparts, Christopher Dillon, vice president and manager of municipal market strategies, writes in the Aug. 20 issue of the firm's "Municipal Market Monitor."
In addition, short and intermediate maturities will be more affected in the secondary market, Dillon says.
For example, at the current top 39.6% marginal tax rate, the additional yield needed to compensate for any possible tax liability if yields climbed 25 basis points would be about five basis points for a one-year bond yielding 2.55%. An investor holding a 30-year bond with an original yield of 5.50% would require only one additional basis point of yield to compensate for a 25 basis point market gain, Dillon calculates.
The J.P. Morgan analyst also recommended that investors consider zero coupon bonds that convert to interest-bearing securities after a stated period to offset tax liabilities. Such securities can offer more price appreciation than a callable premium bond and less downside risk and a smaller tax bite than a discount bond in a rising interest rate environment, Dillon said.
George D. Friedlander, managing director of high net worth portfolio strategy at Smith Barney Shearson, expects that near-term investors will barely feel the effects of the tax law change. This is because in the current market environment, the impact on after-tax yield due to an increase in the tax on the market discount is very small, the analyst writes in the latest edition of the firm's "Credit Market Comment."
Portfolio managers at several mutual fund companies are studying the issue, but are not very concerned about the near-term effects on their portfolios.
"It does make market discount bonds a little less attractive," said Robert A. Dennis, senior vice president and portfolio manager at Massachusetts Financial Services. The firm manages about $7 billion in tax-exempts.
"The greatest effect is on our intermediate fund," Dennis said, adding "the longer you go out in maturity, the less the present value of those taxes are."
"In the intermediate fund, I'll be more careful considering current coupon bonds" which could soon become discount securities, said Dennis, who manages high-grade intermediate and long-term funds with assets totaling about $2.2 billion.
"It makes premium bonds, or cushion bonds, look more attractive," the portfolio manager said.
Premium bonds, which are sold at a price above par, might be more favorable because such securities would have to experience a steeper drop in price than a current coupon bond before becoming candidates for the new tax treatment, Dennis said.
"A lot more thought will be given to realizing a gain in the future. This is a brand-new consideration for us." said Richard J. Moynihan, president of Dreyfus Corp.'s municipal funds.
Dreyfus manages about $28 billion in tax-exempts.
As a result, the firm may move toward a "buy and hold" strategy of purchasing securities and holding them until maturity, to limit the possible taxable gains that are passed onto investors.
But in the near term, Dreyfus expects little fallout from the tax change.
"Munis are at such a high price level now, you have original-issue discount bonds, but there are not too many [other] things out there selling at discounts." Moynihan said.
"Once rates rise, it will be a much more interesting decision time," for fund managers, he said.