One truly fascinating thing about life is how often simple things can create complexity. Consider these statements: Only tax-exempt issuers can create tax-exempt income, and a bond needs to be priced at market yields in order to trade. Both are fairly straightforward, but in the municipal marketplace, the confluence of the two creates complexity.
Investors understand that the value of their bonds will go up and down, and when prices go down, yield goes up. When an outstanding municipal bond is marked down in price so it offers a market yield, the increase in yield is a result of market movements. It’s a market discount totally unconnected to any issuer.
In 1993 the IRS contended that any market discount should be fully taxable. Issuers and underwriters pushed back. They were quick to point out that this would mean bond prices would decline faster than they would rise, because the additional return provided by any accretion back to par would be taxed. To appease the market participants, the IRS agreed to a compromise and created the market discount rule.
The market discount rule states that the IRS will ignore a de minimis amount of market discount. This is defined as one-quarter point of discount for every full year to maturity. For a five-year bond, the discount is 1.25 points; for a 10-year bond, it’s 2.50 points; and for a 30-year bond, it’s 7.50 points. It’s a strict full year, so a five-year bond threshold is 1.25 points, but a 4.99-year bond threshold is one point. The discount is taken from the bond price, and it’s from the lower of $100 or any original issue discount, meaning a new issue price below $100.
The market discount is a threshold, however. Once the market price drops below the de minimis threshold, the accretion of the entire discount becomes taxable. Here’s an example: A five-year bond came with a 2% coupon and was priced at $100. Six months later, the market had sold off, so the de minimis discount is a point (because the bond has four and a half years to maturity). At a price of $99.01, a buyer of the bond would earn not just the coupon but also 0.99% of accreted discount over the life of the bond. Because it’s inside the threshold, the accretion is tax exempt. However, if the price drops further, the full discount would become taxable. At a price of $98.99, a buyer would keep only the after-tax accretion. If they’re in the 35% bracket, that would be 0.64% instead of 0.99%.
Because a buyer’s after-tax return is lower once the bond price falls below the threshold, crossing below the threshold will cause the price to fall even further to arrive at a market price. Using the example above, if the market rate required a tax-exempt discount of 0.99%, a 35% bracket payer would need a 1.54% fully taxable discount to realize the same after-tax return.
Having explained how the rule works, we should stress two important points. First, the pricing is based on the tax status of the bond to a new buyer at market yields. If an investor buys a bond above the threshold, it will be fully tax exempt to them. Ironically this means that, should an investor own a bond whose price has declined so much it’s now below the threshold, they should consider holding it. The cash flows from the bond being fully tax exempt are therefore more valuable to them than they’d be to the next buyer, for whom they would be partially taxable.
Second, since the bond will mature at $100 (absent a default), at some point any market discount will accrete, and the bond price will pass back across the threshold. This means the investor should recoup any de minimis concession as a bond moves toward maturity, though passing back above the threshold may not occur for years.
Finally, understanding the market discount rule may help investors appreciate why so many municipal bonds are issued at a premium. Remember that the discount is calculated from the lower of $100 or an original issue discount. In the example above, the threshold for a bond issued six months ago with an original maturity of five years is $99. If that bond came at $100 with a 2% coupon, it would have a one-point cushion before it would reach the threshold. If the bond came with a 2% yield but a 5% coupon, it would’ve come with a premium price around $115, but in six months, the threshold would still be $99. This bond would have a 16-point cushion before crossing the threshold and experiencing any negative pricing impact.
The bottom line
Understanding the market discount rule can provide important protection. A majority of the new issuance each calendar year continues to be in the higher coupon structure, with roughly 75% of issuance so far this year coming in the 4%–5% range. Investors will continue to find value in premium municipal bonds through not experiencing devaluation because of the de minimis rule.