For tax-exempt municipal bond investors, the recent increase in interest rates from extremely low levels is an issue they have not had to face for some time, and it now has to be factored into their decision-making process.
Over the last eight years, many municipal bonds have been issued with low coupons, thus holding their price close to face value, or par (i.e. $100 for a $100 bond). Holders of these bonds may be in for a double whammy as interest rates increase and the value of these bonds decreases. That is because, as the price of these bonds decreases below $100 to $99, $98, $95, etc., any potential buyer of these bonds will need to account for the potential tax impact they may face even though these are tax-exempt securities. If the new buyer is going to have to pay taxes because of the de minimis rule, they will demand to be compensated for the tax via a lower price for the bond. Thus the value of these bonds will quickly adjust against the current holder. This is all because of the de minimis rule.
The de minimis rule is applied to determine if there is a market discount on a bond purchased in the secondary market. Market discount is not treated as tax-exempt interest to the holder because it arises as a result of market forces (rising interest rates) and not through the action of the issuer.
The de minimis rule exists so that if a bond is purchased with a small discount — meaning a price below $100 — the market discount is considered to be zero. (The small discount is calculated as less than 0.25% x the stated redemption price of the bond at maturity x the number of full years between settlement and maturity). Thus, a small amount of discount is treated like any discount: taxed as a capital gain. Unfortunately, if the amount of the discount is equal to or exceeds this amount, then the entire discount is taxed as ordinary income if there is a gain when the bond is sold or redeemed. http://www.investopedia.com/terms/d/deminimistaxrule.asp
In building tax-exempt bond portfolios I have been very aware of this potential. Market discount municipal bonds can be favorable or unfavorable investments depending on their after-tax yields and must be analyzed accordingly. All else being equal, buying premium (i.e. $101 or greater for a $100 bond) not only allows more defensive characteristics for a portfolio during a rising rate environment but also protects against the de minimis rule from taking effect.
Brian is a Vice President and Senior Portfolio Manager who manages the fixed-income investment process for Wealth Management & Advisory Services clients by providing sophisticated investment counsel and portfolio risk control strategies. Brian is the bank’s primary fixed-income strategist and oversees the strategy, implementation and trading of all fixed-income securities for both private and institutional capital. Brian also holds a Chartered Financial Analyst designation. He has more than 20 years of portfolio management and institutional investment experience. Brian's significant expertise in fixed income is a key to our clients’ financial success, as he positions them to both safe and well positioned portfolios.