EnvisionCap.com: Forbes Article - The Chicago Sewer Conumdrum

The Chicago Sewer Conundrum

Marilyn Cohen, Forbes Magazine, 09.20.99

THIS YEAR'S DOWN MARKET IN BONDS has created some new headaches for municipal bond investors.

Over the past several weeks, as I perused dealers' lists of thousands of offerings, I noticed yield oddities cropping up. There seemed to be a lot of bargains--some high-grade munis yielding 15 to 20 basis points more than comparable issues. For example, I could buy the AAA-rated, Chicago Wastewater Transmission Revenue 5% , due January 2015, at a price of $955 per $1,000 of face, for a yield to maturity of 5.4% , while similar bonds yield 5.2% . You might get a call from your broker on deals like this.

To evaluate these bonds, you need to get out your calculator--and your copy of the tax code. Here's why. Since 1993 muni buyers have had to cope with an obscure statute that can make part of your return taxable as ordinary income when you sell or redeem the bond. If a bond comes out at $1,000, and sinks in price to $900 when you buy it, and you later redeem it for $1,000, your $100 gain is taxable as ordinary income. This is completely unfair, since the $100 did no more than replace some of the tax-free interest you would have collected had you bought a higher-coupon issue. But then, taxes are never fair.

This matter of getting taxed on "market discount" is a potential hazard for just about any muni issued in either 1993 or in 1998, when yields were limbo-low. The sewer bond, it so happens, came out in 1995. Is the $45 per bond of redemption gain going to be hit with tax? Here's where it gets really complicated.

Two rules come into play. First, there's a de minimis exemption from the ordinary-income treatment: When the market discount is small enough, the IRS will let you off the hook and you can treat this gain on redemption as a capital gain, just as you did in the old days for all bonds. A second rule says that original issue discount on a muni bond is treated as a substitute for tax-exempt income, and you don't owe tax on it at either ordinary or capital gain rates.

The de minimis cutoff is calculated by subtracting 0.25% from a bond's original issue price for each year remaining until maturity. So a $1,000 face-value bond that came out at par and has 20 years to maturity, and is selling at $950 or more, is exempt. In 2001 the de minimis cutoff on this bond will be $955; if you pay less than that for the bond, you get stung with ordinary income when you sell or redeem the bond.

Okay, so what was the issue price on the Chicago sewer bond? My handy Bloomberg terminal informs me that it was $967 (forgive me; I am rounding off these numbers). If I buy, I am picking up the bonds for $11 and change less than the original issue price. This $11 will be taxed in 2015 as capital gain. The other $33 or so of gain is exempt from tax, inasmuch as it was built into the bonds when Chicago issued them.

In short, this isn't such a bad deal for a AAA bond investment. Bloomberg calculates that the modest capital gain liability you will confront 16 years hence is only enough to knock a basis point or two off your effective return.

Contrast the Carrollton, Tex. General Obligation 4.45% bond, due in August 2010 and rated AA by Standard & Poor's. It was issued last April at a price of $993 per $1,000 of face. With interest rates now comfortably higher than 4.45% , the bond sells at $945, resulting in a 5.1% yield to maturity.

This is no bargain. Not only is the yield to maturity rather disappointing, the bond is low enough in price that it does not qualify for a de minimis exemption. You will be hit with a tax bill on $47 of ordinary income at redemption. The harsh tax treatment knocks 13 basis points off your effective yield, if you are in the top federal bracket.

If you're the betting type--and want to bet that interest rates will fall from current levels--you might buy a bond like the one from Carrollton and hope rising prices push it into de minimis territory, which would erase the ordinary-income problem and maybe give it a little pop in value. Mind you, I don't recommend trading munis; they're illiquid and the bid/ask spreads are wide. But unforeseen events do occur, and if you have to sell before maturity it would be nice to be selling a bond that doesn't have a tax millstone around its neck.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.