Commentaries

APA Special Market Report – September 2013

By: admin / September 10th, 2013

The De Minimis rule and Municipal Bonds

De minimis is Latin for “about minimal things” and under the U.S. Tax Code refers to the taxation of market discount bonds (original discount bonds (OID) are exempt from the de minimis rule).

In the fixed income markets a market discount occurs when interest rates rise after the issuance of a bond. This is due to the inverse relationship between interest rates and dollar price. As interest rates rise, market dollar prices of bonds fall or, vice versa, as rates fall the dollar price of bonds rise. For example, consider a 10 year bond issued at $100 par with an annual coupon payment of 3% (which was the prevailing market rate at the time of issuance). If interest rates rise to 3.5%, the price of the bond paying 3% would fall to $95.85 due to this inverse relationship (all else being equal). The bond would now trade at a discount to par in the secondary market. (Although, it should be noted that if held to maturity an investor would still receive their full $100 par value upon maturity.)

When a bond is purchased at a discount in the secondary market the gain on the principal when held to maturity is taxable because the discount arises in a market transaction, rather than from an original issuer. The de minimis rule states that the market discount can be treated as zero if it is less than 0.25 of the stated redemption price at maturity multiplied by the number of full years to maturity after acquisition. However, if the discount is greater than the de minimis benchmark, the difference between market discount and the de minimis level is treated as ordinary income instead of capital gains for tax purposes.

To illustrate, we return to the example of the 3% coupon bond in a rising rate environment. Assume that one year has passed and there are now 9 years left to maturity. The de minimis threshold would be calculated as (0.25) x (9) = 2.25 or $97.75. If rates had risen 50 basis points in a year to 3.5% the bonds would be pricing at $96.20 (assuming now 9 years to maturity and all other market conditions have not changed). The investor that buys the bond at the discounted price of $96.20 and holds it to maturity must treat the difference between discount value and the de minimis threshold as ordinary income rather than a capital gain for tax purposes. The difference upon maturity in this scenario is $1.55 ($97.75-96.20) that would be taxed at regular income tax rates (35-45%) rather than the capital gains tax rate (15-20%). However, if the bond had been trading at $98, the discount would then be $2.00 which is less than the de minimis threshold (2.25) and the de minimis rule would not apply.

As bonds begin to approach de minimis levels in a rising rate environment, there is often a sharp drop off in value as buyers need to be compensated for the additional tax they will have to pay for buying a discount bond in the secondary market and holding it to maturity. Market discounts have not been an issue for a number of years as rates have been moving lower. However, as rates continue to rise we will likely see more focus on the ordinary tax impact related to market discounts in the secondary market. Investors can avoid the de minimis issue over time by buying higher coupon longer dated bonds (opposed to lower coupon bonds with short maturities) in their portfolios.  

Disclosures:

Past performance is not indicative of future results. This material is not financial advice or an offer to sell any product. The actual characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market exigencies at the time of investment. Asset Preservation Advisors, Inc. reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. This is not a recommendation to buy or sell a particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein.

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