About the intelligent investor
The weekly column of ‘The Intelligent Investor’ by Jason Zweig, has been published in the Wall Street Journal for about a decade and is published exclusively in Globes. According to Zweig: “My goal is to help you distinguish between the good advice and the one that just sounds good”
About Jason Zweig
One of the senior journalists of The Wall Street Journal. Author of the book “Your Money and Your Mind: How Neuroscience Can Help You Get Rich”, and the editor of the updated version of the bestseller “The Intelligent Investor”, described by Warren Buffett as “the best investment book ever written”
When the herd of investors rushes in one direction, sometimes it pays to go in the opposite direction – but only if you tread carefully.
Consider municipal bonds, which have long been favored by people who want to earn tax-free investment income. The price of municipal bonds has fallen this year in tandem with rising interest rates and the entry of bonds in general into a bear market.
The trend causes many investors to flee. In the first eight months of 2022, investors withdrew approximately $83 billion from mutual funds and ETFs that specialize in municipal debt, according to Refinitiv Lipper data. This is more than any whole year for which there is data.
Now, there are investors sniffing out a deal and tempted by the prospect of capturing higher-yielding municipal debt. “People are excited about the opportunity to earn the higher income,” said Alexa Gordon, manager of municipal debt portfolios at Goldman Sachs Asset Management.
But they may be surprised – or take a beating – if they don’t understand the tricks unique to this field.
Municipal bonds have a unique built-in characteristic. When they reach a price close to par or 100% of their face value, their reaction to interest rate changes becomes strange.
Remember that a bond’s current yield is its annual interest payments divided by its price. When interest rates rise, debt issued later yields higher interest rates, so the price of existing bonds must fall to keep them at a competitive yield. The opposite happens when interest rates fall, because prices and yields move inversely.
The special tax status that causes strange behavior
The special tax status of most municipal bonds, however, makes them behave strangely at times like these. At today’s prices, municipal bonds will often move asymmetrically, losing more when interest rates rise than what they would earn if interest rates were falling.
Learning this lesson, says Gordon, can be “quite painful, and will continue to be so if interest rates continue to rise.”
This oddity happens because the income from municipal bonds is often tax-free, while the gains on them are taxable just like the gains on other assets. This affects the people who trade municipal bonds whose goal is to buy cheap and sell high.
However, this is also true for anyone who buys a municipal bond and holds it until maturity, if the purchase price was lower than the face value of the bond.
If your profit is small – “de minimis” in the language of taxes – it can be taxed according to the rates of taxation on capital gains, up to about 20%. On large profits, the normal income tax is collected, up to about 40%.
As of late 2021, the typical municipal bond was trading at an average price of $109 to $114, according to John Miller, director of municipal finance at Nuveen in Chicago. Until this week, after three weeks of losses, a typical municipal bond was trading between $97 and $101, Miller said.
This means that the returns are on the threshold that allows partial taxation.
Under de minimis rules, the more years remaining until vesting, the lowest price that can be paid before the earnings are subject to taxation starts at a lower point.
For example, you buy a regular municipal bond, which matures in 2032, and pay a price between $97.5 and $99.99. Even if you hold such a bond until it matures, the profit from it will be subject to taxation according to the lower tax rate for capital gains income.
The cheaper the bond, and the higher the yield, the greater the temptation to purchase it. But prices below 97.5 dollars do not meet the threshold of the de minimis rule, and then the profit from such a bond will be more affected by taxation.
It’s not as cheap as it seems – because of the tax
“People who say ‘discount bonds are cheap’ don’t understand that they’re not as cheap as they look,” said Andrew Kalotay, president of Kalotay Advisors, a New York-based company that researches and analyzes municipal bonds. “You have to pay taxes on them.”
Investors who wish to purchase bonds often see before their eyes the price of the bond, the coupon it pays and the yield that can be derived from it. This return, which includes the price or the discount from the face value, can be slightly misleading if it includes a taxable profit.
So how do you buy municipal bonds without getting hit? When you buy individual bonds, prefer new issues at $100 or more, and hold them until maturity.
If you buy at a price that is below the nominal price, ask the broker to tell you exactly at what prices the profit from the bond becomes subject to taxation – both capital gains tax and ordinary income tax. Check recent cases of EMMA trading to make sure that the price offered by the broker does not hover exactly above this dividing line.
If you’re buying municipal bonds through investment in ETFs or mutual funds, check their income distribution history. Large taxable payouts in previous years, says Nuveen’s Miller, could be a sign that the fund is trading the bonds offered at a discount without thinking. on the taxation consequences of this type of trade.
It’s worth looking for deals, but not if you’ll suffer a tax hit later because of them.