Is Capital Loss on Premium Bonds Reflected in Pricing?

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Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby fdeanw » Fri May 17, 2013 8:58 pm

Apologizing in advance if my question displays too much ignorance, but I was wondering whether purchasing an existing-issue bond at a premium and holding it to maturity will result in a capital loss at the time it matures, and if so, whether this factor is generally priced into the premium of the bond. In other words, if I have a choice between purchasing a bond paying, say, 3% at par versus one for the same maturity paying 5% at a premium, presumably the difference in price reflects and would result in the same yield-to-maturity. But does that price differential generally also reflect that the ultimate sale of the bond sold at a premium will result in a capital loss (or smaller capital gain), or would the failure to reflect that impact constitute a reason to favor purchasing the bond with the higher interest rate and premium?
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby ogd » Fri May 17, 2013 9:55 pm

In general, the answer to the question "is X properly priced" should be yes by default, without even bothering to check. If it weren't, some clever Wall Street trader would have already made a mint correcting that mispricing. They don't just leave money on the table like that.

The only exception is taxes. If your question was about the tax advantage of a capital loss, I'm not sure to what degree it's accounted for; the discount is somewhere between 0 and 23.8%. Some investors pay taxes, some don't, and mutual funds care less about it than the average investor because it's a less-visible aspect of fund performance. So I don't know. If you're paying maximum cap gain taxes on the margin, an instrument with an eventual capital loss is probably a good deal to you. On the gain side, there's the concept of OID (Original Issue Discount), but it doesn't seem to exist on the loss side.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby grok87 » Fri May 17, 2013 10:21 pm

fdeanw wrote:Apologizing in advance if my question displays too much ignorance, but I was wondering whether purchasing an existing-issue bond at a premium and holding it to maturity will result in a capital loss at the time it matures, and if so, whether this factor is generally priced into the premium of the bond. In other words, if I have a choice between purchasing a bond paying, say, 3% at par versus one for the same maturity paying 5% at a premium, presumably the difference in price reflects and would result in the same yield-to-maturity. But does that price differential generally also reflect that the ultimate sale of the bond sold at a premium will result in a capital loss (or smaller capital gain), or would the failure to reflect that impact constitute a reason to favor purchasing the bond with the higher interest rate and premium?

I presume you are talking about municipals. This is a more complex question than it appears at first glance. Let me come at the answer in layers:

1) Yes it is generally priced into the bond. in other words the yield to maturity reflects the capital loss.

2) But often these days you may see munis being issued for the same maturity with a couple of different coupon options. For example on a 10 year bond there may be a 4% coupon, a 5% coupon both being offered. The 5% coupon one should obviously be priced at more of a premium, so that the yields to maturity for the 4% and 5% coupon options are roughly the same (yield to maturity for high quality 10 year municipals are around 2%ish or so).

3) Here's the nuance. The yield to maturity for the 4% coupon and the 5% coupon will be roughly the same but not exactly the same. In general the 5% coupon bond should have a slightly lower yield to maturity than the 4% coupon bond, for example. The reason has to do with
a) the artificially low yield environment we are in, and everyone being nervous of rates rising
b) the way that OID works for muni bond.

4) the way that OID works is that if you buy the 10 year 4% bonds today and in say 2 years muni rates jump a lot so that 8 year munis are now yielding 4.5%, then, ignoring OID and tax issues, the price for your bonds should now be at a discount, i.e. less than 100- say 96%. At that point OID taxation starts to apply since the bonds are at a material discount. This is rather nasty and says that the amortization of the 4% discount (100 - 96%) is now taxable. So the bonds are no longer fully tax-exempt. To be clear this does not affect you (you locked in your tax basis when you bought the bonds) but it would affect anyone you might sell them to on the secondary market. So no-one really wants to buy your bonds at 96 any more. Instead the market price may drop to say 92 because of the nastiness of this OID/tax situation.

5) The 5% bonds would still trade at a premium in this scenario so their market price would not be as affected. So right out of the gate, at original issuance,investors look a the 5% coupon bonds as being at less risk of this OID/tax issue down the road and bid up their price relative to the 4% coupon bonds and this means the 5% coupon bonds would have a slightly lower yield.

hope this helps
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby #Cruncher » Fri May 17, 2013 11:37 pm

Edit: The following refers to taxable bonds, not to tax-exempt bonds. I didn't realize until reading his posts below that the original poster was interested in the latter.

Waiting until maturity to reduce your taxable income would make the after tax return from the premium bond worse, not better, than for the bond purchased at par. Here is an example assuming a tax rate of 25%:
Code: Select all
       --------- 3% Coupon -----------       ---------- 5% Coupon ---------   
Year    Pretax      Taxes     Aftertax        Pretax      Taxes    Aftertax
----   --------     -----     --------       --------     -----    --------
  0   (1,000.00)             (1,000.00)     (1,091.59)            (1,091.59)
  1       30.00     (7.50)       22.50          50.00    (12.50)      37.50
  2       30.00     (7.50)       22.50          50.00    (12.50)      37.50
  3       30.00     (7.50)       22.50          50.00    (12.50)      37.50
  4       30.00     (7.50)       22.50          50.00    (12.50)      37.50
  5    1,030.00     (7.50)    1,022.50       1,050.00     10.40    1,060.40
YTM        3.00%                  2.25%          3.00%                 2.23%
The pretax yield to maturity (YTM) is 3% on both bonds. But the aftertax yield is slightly less for the premium bond. However, you don't have to wait until maturity to account for the bond premium. You are allowed to amortize it each year. In this case the aftertax cash flows and YTM would be the same.
Last edited by #Cruncher on Sat May 18, 2013 4:23 am, edited 1 time in total.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby fdeanw » Fri May 17, 2013 11:46 pm

Thanks, Grok. Yes, I was talking about munis, and the reason the question arose is because I was recently looking at an offering that was just the situation you described: a choice between two Cal GO bonds maturing on the same date, one with a 3% coupon and one with a 5% coupon, and both supposedly with the same YTM. It seemed to me that the higher coupon was the plainly better choice because it would allow me to take a capital loss if I held it to maturity (which I am planning to do), and I was wondering whether I was missing something or not.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby grok87 » Fri May 17, 2013 11:54 pm

fdeanw wrote:Thanks, Grok. Yes, I was talking about munis, and the reason the question arose is because I was recently looking at an offering that was just the situation you described: a choice between two Cal GO bonds maturing on the same date, one with a 3% coupon and one with a 5% coupon, and both supposedly with the same YTM. It seemed to me that the higher coupon was the plainly better choice because it would allow me to take a capital loss if I held it to maturity (which I am planning to do), and I was wondering whether I was missing something or not.

Hi fdeanw,
it doesn't really work that way. You are generally not going to be able to take a capital loss because the cost basis of the bond will adjust downward (amortize downward) over time. It's possible if interest rates spike and you sell before maturity that you might be able to take a capital loss. But not if you hold to maturity.

I'll be interested to see how the two different coupons price. According to the logic i laid out, the higher coupon bond should price so as to give a slightly lower yield to maturity. The reason that you are seeing the same YTM right now is that the bonds haven't priced yet so they don't really know how the market will value the different coupons.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby fdeanw » Sat May 18, 2013 12:06 am

grok87 wrote:
fdeanw wrote:it doesn't really work that way. You are generally not going to be able to take a capital loss because the cost basis of the bond will adjust downward (amortize downward) over time. It's possible if interest rates spike and you sell before maturity that you might be able to take a capital loss. But not if you hold to maturity.


So, if I hold to maturity, I can't take a capital loss (ever?) for the premium over par that I paid for the bond? If I bought at, say, $105 and sold a year earlier than maturity at, say, $101, could I take any capital loss in that circumstance?

Cruncher remarked above that I might be able to amortize the premium value over the life of the bond. Is that a way to realize a capital loss and get a deduction for the premium, or would I just be reducing the basis each year?

I suspected that the plan seemed too good to be true. :mrgreen:
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby fdeanw » Sat May 18, 2013 12:09 am

#Cruncher wrote:Waiting until maturity to reduce your taxable income would make the after tax return from the premium bond worse, not better, than for the bond purchased at par. Here is an example assuming a tax rate of 25%:
Code: Select all
       --------- 3% Coupon -----------       ---------- 5% Coupon ---------   
Year    Pretax      Taxes     Aftertax        Pretax      Taxes    Aftertax
----   --------     -----     --------       --------     -----    --------
  0   (1,000.00)             (1,000.00)     (1,091.59)            (1,091.59)
  1       30.00     (7.50)       22.50          50.00    (12.50)      37.50
  2       30.00     (7.50)       22.50          50.00    (12.50)      37.50
  3       30.00     (7.50)       22.50          50.00    (12.50)      37.50
  4       30.00     (7.50)       22.50          50.00    (12.50)      37.50
  5    1,030.00     (7.50)    1,022.50       1,050.00     10.40    1,060.40
YTM        3.00%                  2.25%          3.00%                 2.23%
The pretax yield to maturity (YTM) is 3% on both bonds. But the aftertax yield is slightly less for the premium bond. However, you don't have to wait until maturity to account for the bond premium. You are allowed to amortize it each year. In this case the aftertax cash flows and YTM would be the same.


Cruncher, would the analysis be different with a muni bond, or can you not take any capital loss for the premium in that circumstance?
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby grok87 » Sat May 18, 2013 12:27 am

fdeanw wrote:
grok87 wrote:
fdeanw wrote:it doesn't really work that way. You are generally not going to be able to take a capital loss because the cost basis of the bond will adjust downward (amortize downward) over time. It's possible if interest rates spike and you sell before maturity that you might be able to take a capital loss. But not if you hold to maturity.


So, if I hold to maturity, I can't take a capital loss (ever?) for the premium over par that I paid for the bond? If I bought at, say, $105 and sold a year earlier than maturity at, say, $101, could I take any capital loss in that circumstance?

Cruncher remarked above that I might be able to amortize the premium value over the life of the bond. Is that a way to realize a capital loss and get a deduction for the premium, or would I just be reducing the basis each year?

I suspected that the plan seemed too good to be true. :mrgreen:

This may be helpful- from fidelity's website:
What is amortized premium and how does Fidelity calculate it?
Premium generally arises when a fixed income security is purchased for an amount greater than the total of all amounts payable on the bond other than qualified stated interest. According to federal tax rules, if you acquired your fixed income security at a premium and make the required elections when you file your return, the premium is amortized annually using the constant yield method (also called the yield to maturity method) with semi-annual compounding. If you did not make the required elections, your gain or loss is the difference between your purchase price (as adjusted for wash sales and other required adjustments, if any) and your proceeds at disposition, making no premium adjustments. These rules apply to securities issued at par and to OID securities acquired on the secondary market at price greater than their maturity value. Fidelity calculates amortized premium (and makes corresponding adjustments to the cost basis it provides) using the yield-to-maturity method. For tax-exempt securities, amortization of premium is required and is not deductible from taxable income. For taxable bonds, a tax election may be required in order to amortize premium, and the current year’s amortized premium may be deductible from taxable income. The amortized premium amounts and adjusted cost basis Fidelity provides may not reflect all adjustments necessary for tax reporting purposes. It may not be applicable if you have not made an appropriate tax election or if you are using an alternative amortization calculation method. Review prior adjustments that you have made, and consult your tax advisor and IRS Publication 550, Investment Income and Expenses, for additional information.


looking back at my comments, i see they were not very clear. here is what i think. It doesn't really make a difference tax wise how much of a premium you pay to buy a bond. that is the point #cruncher was making as well i think. your broker will amortize the premium each year and the cash flows will be the same as if you had bought it at par.
what you have to watch out for is buying a bond at a discount on the secondary market. Then you get taxed on the amortization of the discount which is not great.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby fdeanw » Sat May 18, 2013 12:37 am

grok87 wrote: For tax-exempt securities, amortization of premium is required and is not deductible from taxable income.


I guess that's the key sentence for my muni bonds example. Thanks.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby #Cruncher » Sat May 18, 2013 4:29 am

fdeanw wrote:Cruncher, would the analysis be different with a muni bond, or can you not take any capital loss for the premium in that circumstance?
I didn't realize from your initial post, fdeanw, that you were interested in tax-exempt bonds. My post above refers to taxable bonds. I'll leave the discussion of the tax treatment of individual municipals to the experts like grok!
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby tfb » Sat May 18, 2013 12:19 pm

grok87 wrote:I'll be interested to see how the two different coupons price. According to the logic i laid out, the higher coupon bond should price so as to give a slightly lower yield to maturity. The reason that you are seeing the same YTM right now is that the bonds haven't priced yet so they don't really know how the market will value the different coupons.

From recent pricing results on one issue, near-term (<= 2023) bonds were priced to the exact YTM regardless of coupon; longer term bonds had substantial higher YTM when coupon is lower. The issue in question is very small. Maybe it's not typical.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby grok87 » Sat May 18, 2013 5:25 pm

tfb wrote:
grok87 wrote:I'll be interested to see how the two different coupons price. According to the logic i laid out, the higher coupon bond should price so as to give a slightly lower yield to maturity. The reason that you are seeing the same YTM right now is that the bonds haven't priced yet so they don't really know how the market will value the different coupons.

From recent pricing results on one issue, near-term (<= 2023) bonds were priced to the exact YTM regardless of coupon; longer term bonds had substantial higher YTM when coupon is lower. The issue in question is very small. Maybe it's not typical.

Thanks tfb.
The data from that offering is actually quite interesting IMHO. I'll discuss the two maturities you mentioned and advance some hypotheses, in the form of a hypothetical discussion between the issuer, the bond underwiter, institutional investors and (clueless) retail investors. Note I am not meaning to disparage retail investors generally but IMHO retail investors should generally avoid buying individual muni bonds. It is actually a very complex area with opaque pricing and it is quite likely they will be taken advantage of. Stick to vanguard muni funds.

First the data:

Maturity 2023
Amount $150 k coupon 4% yield-to-maturity 2.47%
Amount $1.9 M coupon 5% yield-to-maturity 2.47%

Maturity 2027
Amount $180 k coupon 3.5% yield-to-maturity 3.6%
Amount $2.28 m coupon 5% yield-to-maturity 3.25%

Here's the hypothetical dialogue:

Issuer: I really need to issue some bonds here, but I hate paying high coupons. Ideally I'd love to issue zero coupon bonds- that would really help my cash flow.

Bond underwriter: I hate to tell you this but muni investors mostly want high coupon bond these days. Rates are low, but investors are afraid that if they buy at par with low coupons and then rates go up later, those par muni bonds will then trade at a discount. Then they'll have a hard time re-selling them before maturity if they want to, because those secondary purchasers will have to pay income tax on the amount of the discount. Nobody buys municipal bonds where they have to pay income tax on them-it's completely toxic.

Issuer: Hmm, I see what you mean. Well let's take this one step at a time. I want to sell some 10 year bonds. Yields are around 2.5% right, so what kind of coupon are we looking at here?

Bond underwriter: well let me ask my friend Mr. Institutional Investor A.

Institutional Investor A: I need a 5% coupon and a yield to maturity of 2.47%.

Issuer: 5% coupon!!! Yikes, that is painful. Mr. Bond Underwriter, help!!

Bond underwriter: Hmm. Well I think you are stuck with the 5% coupon for most of the bonds of this maturity. Institutional investor A is kind of calling the shots here as he is taking around 90% of the bonds or $1.9 M. But I may be able to round up some retail investors to take a slightly lower coupon of say 4% for the same 2.47% yield to maturity.

Issuer: But aren't they going to demand a bit higher yield-to-maturity for the greater price risk of the lower 4% coupon?- i.e. since the bonds have a lower 4% coupon, if rates go up in the future they are more likely than the 5% coupon bonds to trade at a discount and hit that tax issue you mentioned.

Bond underwriter: Well in theory yes, but those retail guys don't really know what's going on. Here watch this:

Bond underwriter: Hey Mr. Retail investor, I have this great deal for you. There is this bond offering where institutional investors have basically taken all the bonds. We're talking millions of dollars, here, the big table. But as a special deal for you, I can get you exactly the same yield to maturity of 2.47% as the big guys and you and your 14 friends only have to buy like $10k each. So you are getting "pretty much" the same deal as the big guys here. What a deal huh!

Retail investor: "Pretty much" huh! but wait my coupon is 4% but Mr. Institutional investors coupon is 5%. Does that matter?

Bond underwriter: Not really, no. The yield to maturity is what matters. There might be a difference in how the 4 and 5 coupon bonds' prices behave down the road if rates go up a lot. But no one's worried about that right? Live in the now!!!

Retail investor: where do I sign!?!

Issuer: Boy I'm glad that's over. I always feel a little guilty taking advantage of the retail investors in my state. They are the one's who elected me right? I'm sure glad I have you, Mr. Bond underwriter to do my dirty work for me so I can keep my hands clean. Then if I get asked why institutional investors got a better deal than retail investors I can just wave my hands and blame it on the mysteries of the bond market. Can you imagine if the stock market worked this way!

Bond Underwriter: No problem. Now let's get moving on that 2027 maturity. I've got some bad news for you on this one. Retail investors aren't really interested this time, it's kind of too long for them. So Institutional Investor A wants the same 5% coupon but a yield to maturity of 3.25%.

Issuer: Yikes, is there nothing can be done!!!

Bond Underwriter: Well I do have this one friend Institutional Investor B. He's a little different- an "honest to pete" buy and hold investor. Can you believe it, I thought they were extinct!!!

Issuer: ok, so what is he willing to do?

Bond underwriter: well since he is planning to hold to maturity he doesn't care about the interim price risk from that tax issue. So he'll take a coupon as low as 3.5% as long as he gets a yield of 3.6%.

Issuer: 3.6% yield to maturity! Yikes. I like the lower coupon because it back loads my bond payments. Heck I may not even be here in 14 years. But can I really justify paying this guy a 3.6% yield when the other guys are getting 3.25%? Also since both of these bonds are callable in 2023, institutional investor B is getting an especially sweet deal since his bonds are less likely to be called in 10 years. Say that in 10 years, 4 year bonds are yielding 4%. Then I'm going to want to call the 5% coupon bonds but I'll leave the 3.5% coupon bonds alone. How can I justify giving this guy such a sweet deal-Don't I have a fiduciary duty to get the best deal for my taxpayers?

Bond underwriter: Taxpayers/smaxpayers. You said you wanted a low coupon so you could backload your bond payments right?

Issuer: Yes, Yes I did. And again if anyone asks I guess I can blame all this on the mysteries of the bond market.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby grabiner » Sat May 18, 2013 7:39 pm

fdeanw wrote:Apologizing in advance if my question displays too much ignorance, but I was wondering whether purchasing an existing-issue bond at a premium and holding it to maturity will result in a capital loss at the time it matures, and if so, whether this factor is generally priced into the premium of the bond.


The price will decline, and that is exactly what the premium of a bond is. New 10-year Treasuries are trading near par. 30-year Treasuries issued 20 years ago are also 10-year bonds, but they pay much more in coupon payments before maturity, and thus sell for more than their face value.

However, the IRS won't let you deduct this as a capital loss; you amortize the premium over time, reducing the interest payments for tax purposes. The IRS views the premium as an amount paid in advance for getting above-market payments. (Similarly, if you purchase a bond at a discount and hold it to maturity, the discount is amortized into the interest, so you don't have a capital gain at maturity.)
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby grok87 » Tue May 21, 2013 10:11 pm

grabiner wrote:
fdeanw wrote:Apologizing in advance if my question displays too much ignorance, but I was wondering whether purchasing an existing-issue bond at a premium and holding it to maturity will result in a capital loss at the time it matures, and if so, whether this factor is generally priced into the premium of the bond.


The price will decline, and that is exactly what the premium of a bond is. New 10-year Treasuries are trading near par. 30-year Treasuries issued 20 years ago are also 10-year bonds, but they pay much more in coupon payments before maturity, and thus sell for more than their face value.

However, the IRS won't let you deduct this as a capital loss; you amortize the premium over time, reducing the interest payments for tax purposes. The IRS views the premium as an amount paid in advance for getting above-market payments. (Similarly, if you purchase a bond at a discount and hold it to maturity, the discount is amortized into the interest, so you don't have a capital gain at maturity.)

As discussed, I think we learned that it is only for tax-exempt bonds that you are prohibited from taking the premium as a capital loss.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby grabiner » Tue May 21, 2013 10:15 pm

grok87 wrote:
grabiner wrote:However, the IRS won't let you deduct this as a capital loss; you amortize the premium over time, reducing the interest payments for tax purposes. The IRS views the premium as an amount paid in advance for getting above-market payments. (Similarly, if you purchase a bond at a discount and hold it to maturity, the discount is amortized into the interest, so you don't have a capital gain at maturity.)

As discussed, I think we learned that it is only for tax-exempt bonds that you are prohibited from taking the premium as a capital loss.


This clarification was lost in the backup restoration.

For ordinary bonds, you are not required to amortize the premium, but you usually want to do so; if you don't amortize the premium, you receive the entire premium as interest, and then you get an equal capital loss at maturity, which is less valuable for taxes.
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby Doc » Wed May 22, 2013 8:44 am

grok87 wrote: I'll discuss the two maturities you mentioned and advance some hypotheses, in the form of a hypothetical discussion between the issuer, the bond underwiter, institutional investors and (clueless) retail investors
...


Great story line. When does the movie come out? :beer
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Re: Is Capital Loss on Premium Bonds Reflected in Pricing?

Postby grok87 » Wed May 22, 2013 9:46 am

Doc wrote:
grok87 wrote: I'll discuss the two maturities you mentioned and advance some hypotheses, in the form of a hypothetical discussion between the issuer, the bond underwiter, institutional investors and (clueless) retail investors
...


Great story line. When does the movie come out? :beer

Thanks Doc!
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cheers,
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