Abstract
Tax-exempt municipal bonds (‘munis’) are usually held in taxable accounts. The objective of the manager of such accounts should be to maximize after-tax performance. The standard tool for this is the so-called tax-loss harvesting, i.e. selling a bond at a price below the investor’s tax basis and recognizing the resulting loss for tax purposes. Another, albeit less familiar tax-beneficial transaction, which will be discussed in detail below, is tax rate arbitrage. The economics of sale depend on both the tax associated with selling the bond, or holding it. In Section 2 we provide an overview of the tax treatment of munis. Selling a bond is tax-beneficial only if the after-tax proceeds from sale exceed the bond’s ‘hold’ value, i.e. the value of the bond to its current holder. As discussed in Kalotay [2016a, 2016b], in the case of munis hold value can substantially differ from the market price. Hold value is a critical input into after-tax analysis, and in Section 3 we illustrate the calculation of hold value in the case of tax-loss harvesting. In Section 4 we describe what we call the ‘tax rate arbitrage’ strategy and demonstrate how it is calculated. Tax rate arbitrage entails a tradeoff between paying tax earlier at a lower rate or later at a higher rate. The discount rate applicable to the tax at maturity is a critical input into this analysis. Any tax-beneficial sale is an exercise of the so-called tax option. The tax option is acquired automatically and at no cost when a taxable account invests in a security, such as a muni. As discussed in Kalotay [2016c], for investment-grade bonds the value of the tax option can be determined using standard analytical models, such as tax-neutral OAS analytics in the case of munis [Kalotay, 2014a]. Selling and reinvesting the proceeds entails swapping the associated tax options. If the sale is cashflow beneficial, by reinvesting in a like bond (i.e. one with similar interest rate and credit exposure) the investor can realize a riskless gain. The deterrent to transacting is the related transaction cost. The so-called tax efficiency measure, which compares the cashflow benefit to the net loss of option value, provides the signal for the optimal time to transact [Kalotay, 2014b]. These calculations are illustrated in Section 5.
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