How Market Discount Rules Wrecked Muniland

Last week, you may recall, I answered a reader's question about why a municipal bond he owned had dropped so much in price, as measured by the indications given on his brokerage statement.

Turns out I missed a couple of important points. For that I'm sorry, and grateful to everyone who emailed me to point them out. Please don't ever hesitate to do that!

The story wasn't incorrect in any respect, just incomplete. The reader inquired about a 30-year bond, probably the 5.10% coupon Southwestern Illinois Development Authority for Illinois American Water insured water facilities revenue bond issued last June. His statements detailed a drop in price over the next seven months from par (100 cents on the dollar) to about 80. Those prices mesh with what Standard & Poor's J.J. Kenny, a municipal-bond pricing service, says happened to the bond over that period.

I explained that as a long-maturity and insured bond, this bond was extremely price-sensitive, meaning that as interest rates rise, as they have for the better part of the last year, it experiences severe price deterioration.

What I missed:

First of all -- and perhaps this will answer the concerns of those who were outraged that the reader was sold such a long-maturity instrument, when nearly as much yield can be had from a shorter-maturity bond -- this bond was special in a key respect.

The $31 million issue, which consisted entirely of 30-year bonds, was underwritten by Edward Jones, the St. Louis-based regional brokerage. And it came with a kind of put option for the investor's heirs, explains Bob Beck, head of the firm's municipal department.

The option is called an estate feature, and it works this way: If you own this bond and you die, your heirs can redeem it at par, collecting up to $25,000 of par value a year.

That's important because it partially explains why this bond initially sold at a yield -- 5.10% -- significantly lower than where otherwise comparable bonds were trading at the time, around 5.30%.

The other reason investors got a below-market yield is because individual (as opposed to institutional) investors always do, and this issue, because of the estate feature, was sold entirely to individual investors.

It's a fact of life in bondland. It costs a brokerage house a certain amount of money to do a bond transaction, regardless of the size. If you are an individual investor buying an odd lot of bonds (less than $100,000 par value), you will pay a higher price than an institutional investor buying a round lot. A higher price equals a lower yield. Beck says his average muni bond order size is $15,000.

In any case, the lower-than-normal 5.1% coupon rate makes for even more price sensitivity than there would have been had the bond carried a more normal (at the time) 5.3% coupon.

Hairy Tax Issue

The other thing I missed is tax-related, and it's hairy, so brace yourself.

People who bought this bond as a new issue do not have to worry about taxes, unless they manage to sell it for more than par before it matures (not a possibility at the moment, obviously), or unless they have to pay the alternative minimum tax. The interest, while exempt from federal and Illinois income taxes, is subject to AMT.

However, anyone buying this bond (or many other muni bonds) today in the secondary market would incur an ordinary income tax liability, due to the so-called market discount rules.

Before the introduction of the market discount rules in 1993, if you bought a bond that had been issued at par at a price below par, and either held it to maturity or sold it at a higher price, you had to pay capital gains tax on the difference between the price you paid for it and either par (if you held to maturity) or the price you sold it for.

The market discount rules changed that, as follows. They set a price threshold below par, according to maturity. For each year till maturity, a bond gets 1/4 point for its price threshold. So a 30-year bond's price threshold is set at 7.5 points below par, or at a price of 92.5.

Above the price threshold, the old rules apply, meaning that someone who buys a bond at a price north of the threshold incurs a capital gains tax liability if he holds to maturity or sells at a profit.

But if you buy a muni bond below the price threshold, then the entire difference between your purchase price and either par (if you hold to maturity) or your selling price is considered ordinary income, and taxed at higher rates.

As a result, when a muni bond's price drops below its so-called de minimis threshold, its decline accelerates, because potential buyers are pricing in the fact that any gain on the bond will be taxed at a higher rate.

The bond in question saw its price decline accelerate substantially for this reason once it dropped below 92.5.

It is not alone. The rise in muni bond yields over the last year has loads of bonds trading below their de minimis thresholds.

A final point. A few readers wondered whether the price the investor saw on his brokerage statement represented the price at which the broker was willing to buy the bond back, or in other words, whether the price was so low in part because the broker would buy the bond back only at a significantly below-market price. This is not the case. Bond prices on brokerage statements are mere approximations of what a bond is worth, usually provided by a third-party data vendor. They are not an offer to buy the bond at that price. A broker's bid for a bond might be higher -- or lower -- than the price that appears on a brokerage statement.

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