Read the weekly bond market commentary from Doug Drabik.
November 19, 2018
It is the season of tax swaps. With the large swings in the equity markets, many investors find themselves in the enviable position of dealing with market gains leading some to seek the shelter of utilizing portfolio losses to offset these gains. Frequent questions arise concerning how municipal bonds can be utilized to relieve some of an investor’s tax burden or in some cases how replacement bonds may fit the overall portfolio strategy as more and more issues are being offered at discounts.
In most circumstances, market discounts are bonds priced below par. The difference between the redemption price (typically par) and the purchase price reflects the market discount. Market discounts are taxed in the year of sale or redemption at the investor’s ordinary income tax rate. The price appreciation gained during the holding period is the amount being taxed, not the interest earned. In a tax-exempt municipal bond, the interest earned is federally tax-exempt.
The IRS allows for very small, or de minimis, amounts to be taxed as a capital gain (which is typically a lower tax rate versus ordinary income). The de minimis amount is an amount less than 0.25% of the face value of the bond times the number of complete years between the acquisition date and maturity date.
- Par issue, 5 years to maturity = $100 – (.25 x 5) = $98.75
- If purchased at $98.75 or higher >>> amount taxed as capital gain (de minimis applied)
- If purchased below $98.75 >>> amount taxed as ordinary income
- If purchased above par >>> no accretion, no tax consequence
Original Issue Discounts (OID) (the difference between the original issue price and face value of a bond) are different from Market Discounts. A recognizable example would be zero coupon bonds. The original discount on the zero coupon issue represents the interest earned and therefore is federally tax-exempt just like the interest earned on a coupon bond. If the discount exceeds the OID, that difference would be a market discount.
As we approach year’s end, timing is good to seek out one of the few tax shelters left for investors. Contact your advisor if you feel you can benefit from a tax loss swap. Be sure to consult your tax advisor to ensure a proper understanding of any tax consequences as Raymond James is not a tax expert and does not provide tax advice.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.