Tax risk within the tax-exempt market escalates in a rising rate
environment. Buying premium bonds is one way PIMCO seeks to protect client
portfolios from this risk.
One of the primary benefits of municipal securities is that coupon income
received, in most instances, is exempt from federal income taxation. It’s
important to remember, however, that the price appreciation of securities
purchased at a discount in the secondary market can be taxable. The rate at
which these discounted securities will be taxed depends on a somewhat
obscure section of the Internal Revenue Code referred to as the de minimis
In a rising rate environment, the de minimis rule creates a potential tax
risk that can have a meaningful impact not only on the after-tax returns of
investors in the upper tax brackets, but also on how municipal securities
are priced. Indeed, it is one of the reasons PIMCO’s municipal bond
portfolio managers often prefer to buy bonds priced at a premium. Here we
explain the basics of the de minimis rule and discuss its potential
significance for municipal bond investors.
DE MINIMIS RULE BASICS
Essentially, the de minimis rule determines whether the price appreciation
(also referred to as price accretion) of securities purchased at a discount
will be taxed at the ordinary income tax rate or the capital gains tax
rate. Prior to the early 1990s, this accretion was treated as a capital
gain. In 1993, however, the federal tax code was revised to treat the
accretion of discounted municipal bonds as ordinary income, but with
certain key exceptions applied to smaller market discounts.
The de minimis rule states that if a discount is less than 0.25% of the
face value for each full year from the date of purchase to maturity, then
it is too small (that is, de minimis) to be considered a market discount
for tax purposes. Instead, the accretion should be treated as a capital
The de minimis threshold price determines whether the accretion of the
market discount is taxable at the ordinary income or the capital gains tax
rate. It is defined as follows.
For some municipal investors – particularly those in higher tax brackets –
taxation of bond’s market discount can have a noteworthy impact on
after-tax returns. For a discounted municipal security purchased at a price
below the de minimis threshold, price accretion is subject to the ordinary
income tax rate (43.4% for top earners1). Conversely, the
accretion of a security purchased at a discount, but at a price above the
de minimis boundary, is subject to a much lower capital gains tax rate
(23.8% for top earners) if the bond is held for longer than one year. 2
IMPACT OF MARKET DISCOUNTS IN A RISING RATE ENVIRONMENT
Since the financial crisis, the U.S. economy has experienced an
extraordinary period of declining and persistently low interest rates. As a
consequence, municipal bond investing has not required careful
consideration of the de minimis tax rule. The majority of the municipal
market does not currently price below the de minimis threshold, and given
low interest rates, most municipal securities trade at a premium.
In a rising rate environment, however, declining bond prices would imply
that more municipal securities could fall below the de minimis threshold.
Also, prolonged low interest rates have contributed to an uptick in
municipal issuance with lower-coupon bond structures at lower prices than
their higher-coupon counterparts.
As higher interest rates drive bond prices lower, those securities issued
at or near par may now be more vulnerable to negative tax and liquidity
implications associated with the de minimis rule.
Tax impact. Given the higher tax rate any buyer would incur as a result
of purchasing bonds below the de minimis threshold, securities trading near
or below the boundary will likely trade at an even lower price (and higher
yield) to compensate investors for the impact of additional taxes.
- Liquidity impact. Potential taxes associated with the de minimis rule may
also lead to demand distortions in the marketplace as the result of a
reduced buyer base. The traditional tax-sensitive municipal buyer may shun
securities with any tax consequences, even in instances when yields
compensate investors for the higher tax treatment.
These dynamics, in effect, may create a “price cliff” as bonds approach the
de minimis cutoff. The impact of higher taxes and diminished liquidity may
cause bond prices to deteriorate more rapidly than they otherwise would if
the price was higher and further from this threshold.
THE SIGNIFICANCE OF RISING RATES: AN EXAMPLE
Consider the following example using a municipal security that was issued
at par with 10 years to maturity:
- If the security was purchased below $97.50, the entire accretion
from the purchase price to $100 would be subject to the ordinary
income tax rate (43.4% for top earners)
- If the security was purchased at a price between $97.50 and $100, the
entire accretion from purchase price to $100, under the de minimis rule,
would be subject to the capital gains tax rate (23.8% for top earners) if
held for greater than one year
- If the security was purchased at a premium ($100 or higher), there would
not be accretion (or tax consequences) associated with the bond as it
Now consider the pricing impact that additional taxes may have on a bond
trading below the de minimis cutoff in a higher rate environment:
Assume a 4% coupon bond with a 10-year final maturity issued at par.
- If rates increase 50 basis points, the same credit could be issued at par
with an identical maturity date and a 4.5% coupon.
- An investor who is unfamiliar with the de minimis rule might believe the
previously issued 4% coupon bond only needs to trade down to approximately
$96 (to produce a market yield of 4.5%). However, the bond would then have
fallen below its de minimis threshold of $97.50 (as solved for above).
- Accounting for the tax implications associated with its market discount,
the security would need to trade closer to a dollar price of $93 to produce
an after-tax return of 4.5%3 for high-income individuals. Diminished
liquidity may even cause the bond to trade below $93.
HOW PIMCO HELPS INVESTORS MANAGE THESE POTENTIAL
PIMCO favors municipal bonds priced at a premium, in part because they are
less likely to be subject to the tax, liquidity and ultimately price
consequences associated with the market discount issue. In a rising rate
environment, municipal bonds purchased at a premium should provide a
greater cushion from the de minimis threshold compared to discount or par
securities. Higher coupon premium securities may also offer additional
protection against rising rates since the front-loaded cash flows (via a
higher coupon payment) reduce the security’s overall duration (or market
sensitivity to interest rate changes).
Although many investors view their municipal allocation as buy and hold to
maturity, credit deterioration or unforeseen cash requirements may
necessitate future bond sales even in buy and hold portfolios. Therefore,
the potential impact of the de minimis rule should still be considered when
choosing between par and premium bonds.
In a rising rate environment, it may be more difficult to liquidate market
discount securities because of the tax and liquidity implications
associated with the de minimis rule. By maintaining an investment bias
toward premium securities and focusing on after-tax returns, PIMCO seeks to
protect municipal portfolios against the potentially adverse effects of the
de minimis market discount rule.