and Bond Returns
2005 - The tax laws governing the returns from holding bonds
are complex and change frequently. The law distinguishes
between the two components of return: interest income and
capital gain or loss. Capital gains or losses are further
classified as short term (bonds owned for one year or less)
or long term. Short-term gain is taxed at the marginal tax
rate on ordinary income, currently as high as 35%. For investors
in the 25% bracket or higher, the current long-term capital
gains tax rate is 15% (5% for investors in the 10% and 15%
brackets). Interest income is always taxed at the investor’s
marginal tax rate.
losses can be deducted except in the case of “wash
sales.” A wash sale is defined as a sale within 30
days of the acquisition of a substantially similar property.
This rule does not apply to dealers and excludes acquisitions
by gift bequest or inheritance. The general deduction procedure
is as follows: First, losses and gains are netted within
each category. Short-term losses should be deducted from
short-term gains, and long-term losses should be deducted
from long-term gains. If all losses are absorbed in this
fashion, the relevant tax rates apply. Net losses in either
tax category can be applied against the other. Note that
this would reduce the tax shield from short-term losses
for investors whose marginal tax rate exceeds 15%. Remaining
net capital losses can be deducted from other income, up
to $3,000 per year. If net capital losses exceed $3,000,
they can be carried forward to future years.
addition, for tax purposes, interest income and the bond’s
coupon payments are not equivalent. Similarly, capital gain
or loss is not equal to the appreciation or decline in the
market price of the bond. Both interest income and capital
gains or losses are determined by the bond’s tax basis.
The basis of a bond initially equals the total purchase
tax law equates the basis to the present value of future
coupons and the principal, with the bond’s yield to
maturity at purchase serving as the discount rate. For a
par bond, this produces a basis that remains constant during
the holding period. For a premium bond, the basis declines
(i.e., is amortized) until it reaches the principal value
at maturity. For a discount bond, the basis increases at
the rate of the accrued market discount until it reaches
the principal value at maturity. This
increment may be included in income on a ratable basis.
With the exception of municipal bonds (discussed below),
it is irrelevant for tax purposes whether the discount is
a market discount or an original issue discount (OID), bonds
issued at prices substantially below par. Interest income
in any year is defined as the annual coupons plus the change
in the basis over that year. Realized capital gain or loss
is defined as the difference between the sale price and
the current basis.
important difference in the taxation of interest income
and capital gains is the investors’ ability to defer
taxes on capital gains until they are realized. The only
deferrable taxes on interest income occur when a bond is
purchased at market discount, in which case part of the
interest income (the accrued market discount) can be deferred.
the definitions of interest income and capital gains on
tax-exempt municipal bonds are identical to the definitions
for taxable bonds, their taxation is different. Not all
of the interest income from municipal bonds is tax exempt.
Interest paid by the issuer of a municipal bond is always
tax exempt regardless of whether it is in the form of coupon
payments or in the form of an OID. The accrued interest
generated upon disposition by a market discount, however,
is always taxable. Because buyers of premium municipal bonds
do not pay taxes on coupon income, they do not receive any
tax breaks on the amortization of the premium either. Exhibit
1 summarizes the differences in the taxation of returns
on premium bonds, market discount bonds, and OID bonds for
both taxable and tax-exempt municipal bonds.
mutual funds have only just begun appearing in the marketplace.
Little research exists in the area of the after-tax returns
of bond mutual funds. Some research indicates poor after-tax
performance of equity funds. More work is needed in the
development of appropriate after-tax benchmarks. Investors
also need to be disciplined and should have longer investment
horizons to avoid paying the higher income tax rate and
generating trading costs.
has demonstrated that a simple buy-and-hold strategy is
not optimal when personal taxes are taken into consideration.
Optimal tax-induced trading may include realizing a capital
loss, deferring capital gain, changing long-term status
to short-term status (via sale and repurchase), realizing
future losses in the short term, raising the basis above
par (via sale and repurchase), and deducting the amortized
premium from ordinary income.
Short-term loss realization. Consider a three-year
maturity par bond paying 10% percent annual coupons that
is bought by an investor in the 28% income tax bracket with
a three-year investment horizon. Because the bond is purchased
at par, its basis will equal $1,000 throughout the investor’s
holding period. If the investor holds the bond until maturity,
$28 is the tax on annual coupons. The after-tax yield is
that at the end of the first year the yield rises to 15%,
resulting in a decline in market price to $918.71. The bondholder
could realize a short-term capital loss by selling the bond
and repurchasing. If he chooses the latter, a capital loss
of $81.29 is realized, generating tax savings of $22.76
and reducing the basis to $918.71. At maturity, the bondholder
pays taxes on the accrued interest of $81.29, which increases
taxes at the end of Year 3 by $22.76. Incremental after-tax
cash flows caused by the sale are shown in Exhibit
2. This is effectively an interest-free loan of $22.76,
which the bondholder repays at maturity. This strategy should
be pursued only if it is profitable once the transaction
costs are considered.
Increasing the basis above par. Given the
conditions above, assume that at the end of the first year
the yield drops to 5%, resulting in an increase in the market
price to $1,092.97. The bondholder could realize long-term
capital gain of $92.97 by selling the bond and repurchasing
it. This would generate a tax bill of $18.59 (at a 20% tax
rate). Why would a bondholder decide to increase his tax
bill? The transaction will also increase the basis of the
investment to $1,092.97 and would allow the bondholder to
deduct the corresponding value of the amortization from
the coupon income (taxed at 28%). Exhibit
3 presents incremental after-tax cash flows from the
transaction. The transaction amounts to the bondholder’s
extending a loan of $18.59, which the government repays
in two unequal annual installments of $12.70 and $13.33.
The internal rate of return of this tax-free loan is 25.45%.
If the strategy of increasing the basis above par is not
profitable due to the transaction costs, then by default
the strategy of deferring capital gains dominates.
and Bond-Market Equilibrium
above examples show that changes in interest rates might
allow an investor planning to hold a bond until maturity
to increase the present value of the after-tax cash flows
through tax arbitrage. As a result, the value of a bond
for a taxable investor should be higher by the value of
the tax-timing option. Whether or not the value of the tax-timing
option is reflected in the bond prices depends on the tax
status of the marginal bondholder.
of municipal and taxable bonds provides insight into the
impact of taxes on bond prices. A comparison of short-maturity
tax-exempt bonds and Treasury bonds reveals that tax-exempt
yields are lower than taxable yields by 25%–35%. This
empirical evidence suggests that the marginal bondholder
is taxable and the market equilibrates on an after-tax basis.
The estimated value, however, does not necessarily represent
the marginal tax rate of the marginal investor.
it is possible that investors with different marginal tax
rates prefer different bonds, in terms of their tax status,
maturity, or coupon rate. Consequently, different tax-clienteles
may be “setting” prices for different types
of bonds. Schaefer (“Taxes and Security Market Equilibrium,”
in Financial Economics: Essays in Honor of Paul H. Cootner,
1982) examined a capital market with redundant securities,
where investors face heterogeneous marginal tax rates and
no frictions other than taxes, and found that equilibrium
is impossible because arbitrage opportunities exist. Introducing
frictions such as trading costs and short-selling constraints
can preclude arbitrage and generate equilibrium.
investors may optimally follow complex tax-induced trading
strategies, which would differ across taxable and tax exempt
instruments. Thus, both the tax clientele and the tax-timing
option imply that the ratio of taxable and tax-exempt yields
would not equal the tax rate of the marginal investor. Nevertheless,
taxes have an important effect on bond prices that investors
should be aware of.
bonds allow one to defer taxes indefinitely. Taxes on Treasuries
are deferred at least until the end of the current tax quarter
(when an estimated tax payment will be made). Consistent
with the prediction that intra-year changes in the tax-exempt-to-taxable-yields
ratio should reflect changes in the tax deferral, one study
(S. J. Hochman, O. Palmon, and A. P. Tang, “Tax-Induced
Intra-Year Patterns in Bond Yields,” Journal of
Finance 48, 1993) found that the yields ratio exhibited
a sawtooth pattern varying between 0.55 and 0.58. Green
and Odegaard (“Are There Tax Effects in Relative Pricing
of U.S. Government Bonds?,” Journal of Finance
52, 1997) examined the effect of the 1986 Tax Reform
Act using a sample of pre- and post-1986 prices of U.S.
Treasury bonds. Their estimates of the implicit tax rates
are positive (mean estimated tax rate is 16.05%), and significant
for the pre-1986 era, but are close to zero for the period
following the act. The authors attribute this difference
to changes in both the tax laws and the institutional environment.
By redefining market discount as interest income and requiring
linear amortization of the market premium, the 1986 act
reduced the magnitude of tax effects on bond valuation.
In addition, the rise of derivatives markets and the increased
variety of Treasury bonds in this period enhanced the ability
of symmetrically taxed institutions to arbitrage away any
prime-grade municipal bonds trade at a premium relative
to taxable Treasuries; however, this premium declines with
maturity. Several explanations of this puzzle have been
proposed. First, it is possible that higher default risk
and the call features of long-term municipals may explain
the relation. Research (C. Trczinka, “The Pricing
of Tax-Exempt Bonds and the Miller Hypothesis,” Journal
of Finance 37, 1982) has found, however, that the puzzle
persists when the municipals are compared to corporate bonds
of similar credit rating. J.M.R. Chalmers’ “Default
Risk Cannot Explain the Muni Puzzle” (Review of
Financial Studies 11, 1998) examined a sample of municipal
bonds secured by the U.S. government and found that long-term
yields on these bonds were higher than predicted by theory.
Because the bonds are effectively risk-free and noncallable,
the author ruled out default risk and the call feature as
sources of the long-term-yield differential.
explanation for Chalmers’ results is the tax-timing
option, the value of which increases with maturity. The
tax-timing option increases the value of a taxable bond,
and more so for longer-term bonds. It is not clear, however,
whether the tax-timing option affects bond prices significantly.
R.H. Litzenberger and J. Rolfo (“Arbitrage Pricing,
Transaction Costs and Taxation of Capital Gains,”
Journal of Financial Economics 13, 1984) examined
this issue by focusing on three government bonds with the
same maturity. The value of a tax-timing option attached
to a single bond is lower than the value of an option attached
to a bond portfolio with a promised stream of cash flows.
This could exist only if trading costs or short-selling
constraints prevent arbitrage by tax-exempt investors. The
results supported the tax-timing option hypothesis and showed
that its effect on bond prices is bounded by the no-arbitrage
condition for tax-exempt investors.
1986 act began a phase-out of the interest paid on borrowings
other than a residence. An analysis of the components of
household debt before and after the tax act (D.M. Maki,
“Household Debt and the Tax Reform Act of 1986,”
American Economic Review 91, 2001) found that households
moved their portfolios away from consumer debt into mortgage
debt, supporting the contention that taxes affect consumer
and Corporate Debt Financing Behavior
also affect the behavior of the corporate, municipal, and
government entities that issue bonds. This affects the supply
side of the equation and thus bond returns. One advantage
of debt financing for corporations is the tax-deductibility
of interest payments. Companies with net operating losses
have zero tax liability, and losses can be carried back
or carried forward to reduce tax payments.
evidence is consistent with this theoretical prediction.
Graham (“Debt and the Marginal Tax Rate,” Journal
of Financial Economics 51, 1996) found that companies
with high marginal tax rates were more likely to issue new
debt. Similarly, Manzon et al. (“Evidence on the Effect
of Taxes on Firms’ Decisions to Retire Debt Early,”
Journal of Financial Research 19, 1996) showed
that companies with low marginal tax rates were more likely
to retire their debt early. They also found that sometimes
companies retired their debt at a loss when such a loss
could be immediately deducted from their taxable income.
Graham (“How Big Are the Tax Benefits of Debt?,”
Journal of Finance 55, 2000) also found that companies
with large market capitalization, high liquidity, and high
profitability used debt conservatively. The tax benefit
of debt was found to be about 10% of firm value and about
4% net of personal taxes.
(R. Varma and D. Chambers, “The Role of Financial
Innovation in Raising Capital: Evidence from Deep Discount
Debt Offers,” Journal of Financial Economics
26, 1990) has examined the stock market effects of announcements
of new issues of OID bonds in 1981–1982. Because OID
bonds are issued with coupon rates well below the market
yields and issue prices that are below par, the coupon payments
represent only part of the return; the balance is paid along
with the principal at maturity.
and Chambers hypothesized that the impact of OID bond issuance
on shareholder wealth may differ from the impact of par
bond issuance. Until July 1982, OID bond issuers could deduct
a fixed straight-line portion of the original issue discount
from their income every year. This rule ensured that the
present value of the tax shield provided by OID bonds was
higher than that provided by par bonds. A decision to issue
an OID bond might signal that managers expect to have enough
earnings to utilize extra tax shields. Investors react favorably
and push the stock price up. The authors found positive
significant (0.8%) two-day abnormal returns upon announcements
of OID bonds. These abnormal returns disappeared after 1982.
the 1980s, numerous high-yield bonds were issued at substantial
discounts to face value (high-yield discount obligations;
HYDO) paying low coupons or none at all, instead making
payment-in-kind, PIK, distributions. These bonds were used
to finance many highly leveraged transactions. Under the
prevailing tax law, the accrued market discount was deductible
as an interest payment, even though the payment was made
much later at maturity. The Revenue Reconciliation Act of
1989 made a certain portion of this discount deductible
only at maturity, and a certain portion disallowable depending
upon the yield of the bond at issue compared to the Treasury’s
yield of similar maturity. The issuance of such bonds diminished
greatly after the 1989 act.
taxation of interest income, as well as long- and short-term
capital gains, creates incentives for investors to follow
tax-induced trading strategies. Such trading strategies
might allow investors to increase their after-tax returns
more than a simple buy-and-hold strategy. Companies have
tended to overuse existing holes in the Tax Code, which
has led to legislation changing the tax structure.
Bali, PhD, is an assistant professor (finance)
at Adelphi University, Garden City, N.Y. He would like to
thank Charles Barragato, Gailen Hite, Armen Hovakimian, and
Bob Willens for their comments.