Does it matter whether I buy low-coupon or high-coupon Treasuries?

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lgs88
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Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by lgs88 » Fri Feb 14, 2020 12:14 pm

All,

In this low-yield environment, I'd like to dodge the expense ratio on bond funds, so I'm looking to buy individual Treasuries (5-years).

For tax purposes, does it matter whether the Treasuries have high or low coupons? I'd expect the yield to be the same for all Treasuries maturing in five years; suppose the only difference is whether that yield is expected to come from the coupons of from capital appreciation.

lgs88
merely an interested amateur

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Wiggums
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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by Wiggums » Fri Feb 14, 2020 12:41 pm

I think this is what you are referring to.

The key concept here is called Yield To Maturity (YTM). This is the yield that bond has when held until its redemption date. It is calculated from the coupon and the price the bond trades at today. (Which may not be face.) What happens is that as interest rates rise and fall, the price that a bond will buy or sell for adjusts so that the YTM matches the current YTM of new similar bonds.

Let's look at an example using some simple numbers. Suppose that we have two treasury bonds that have 5 years left on them. (They were issued at different times with different maturities.) One pays 4%, one pays 2%. Now suppose that the yield of newly issued 5 years treasuries is 5%. What will happen? The price of the two bonds will adjust down until the effective yield based on the price the bond trades for is 5%. The price of the 4% bond will have to fall by about 4.5% of face, and the price of the 2% will fall by about 13% of face.

It's always good remember that bond prices and interest rates are on a seesaw. As rates go up, price of existing bonds go down and vice versa.

cas
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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by cas » Fri Feb 14, 2020 12:54 pm

The mechanics of tax reporting are a bit different depending on whether the secondary market (treasury) bond/note/whatever is bought at a market discount or a market premium.

I always have to look the details up, so I'll just leave my comment at that.

For taste of what I'm taking about:

Bond amortization and accrual elections at vanguard.com

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lgs88
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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by lgs88 » Fri Feb 14, 2020 1:25 pm

Wiggums wrote:
Fri Feb 14, 2020 12:41 pm
I think this is what you are referring to.

The key concept here is called Yield To Maturity (YTM). This is the yield that bond has when held until its redemption date. It is calculated from the coupon and the price the bond trades at today. (Which may not be face.) What happens is that as interest rates rise and fall, the price that a bond will buy or sell for adjusts so that the YTM matches the current YTM of new similar bonds.

Let's look at an example using some simple numbers. Suppose that we have two treasury bonds that have 5 years left on them. (They were issued at different times with different maturities.) One pays 4%, one pays 2%. Now suppose that the yield of newly issued 5 years treasuries is 5%. What will happen? The price of the two bonds will adjust down until the effective yield based on the price the bond trades for is 5%. The price of the 4% bond will have to fall by about 4.5% of face, and the price of the 2% will fall by about 13% of face.

It's always good remember that bond prices and interest rates are on a seesaw. As rates go up, price of existing bonds go down and vice versa.
Thank you, Wiggums.

As I understand it, a Treasury that matures in February 2025 will have the same YTM regardless of when it is issued. However, the bond coupon will be different. Does that different coupon have any tax consequences -- e.g., will I pay more in taxes over the life of the bond with the higher coupon? All other things being equal, is there any reason to prefer a bond with a lower coupon?
merely an interested amateur

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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by ochotona » Fri Feb 14, 2020 4:13 pm

If you pick the one with the lower coupon, won't you pay less taxes, if it's in a taxable account?

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lgs88
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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by lgs88 » Fri Feb 14, 2020 4:40 pm

ochotona wrote:
Fri Feb 14, 2020 4:13 pm
If you pick the one with the lower coupon, won't you pay less taxes, if it's in a taxable account?
Ochotona,

That's what I was thinking, but I wanted to run it by the investment brains at the BH forum first! This is probably splitting hairs, though, what with yields being so low.

lgs88
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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by GrowthSeeker » Fri Feb 14, 2020 4:53 pm

I haven’t thought this through, but I assume that if you buy at discount then hold to maturity, you’d have a capital gain; and if you held the bond over a year, it would be LTCG taxed at (for many people) 15%.
Does this mean you can control how much of your total return is taxed at your marginal income tax rate vs your LTCG rate?
Just because you're paranoid doesn't mean they're NOT out to get you.

ofckrupke
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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by ofckrupke » Fri Feb 14, 2020 5:00 pm

Approximately speaking, it doesn't matter.

If your marginal rate regime at disposition will particularly favor LTCG income over regular interest (typically the highest brackets), then you can get more benefit than others from the de minimis exception which allows specifies the accretion of sub-threshold (1/4% per years to maturity at acquisition) market discounts to be accounted as capital gain rather than as an upward adjustment to interest income. OTOH this is well known and probably distorts market pricing near the threshold, so a middle-bracket secondary-market investor probably wants to select from issues closer to par xor with discounts exceeding the threshold.
n.b. depending upon state tax rate on capital gain income, one may be strictly better off skipping available avoiding de minimis exceptions for disposed/matured treasuries...in which case why compete in acquisition with those seeking to maximize their benefit under the exception.

Other differentiators are arguably smaller/higher order and probably affect investors more uniformly across brackets. For instance, bonds that mature on a weekend date can't be rolled to a new auction issue without at least one day of lost interest. Between compensatory market pricing at acquisition, auction pricing for nearest subsequent issuance, and overnight sweep rates offered by broker, this is unlikely to be fully compensated. But the remanent effect must be tiny for issues maturing more than a year after acquisition.

For someone composing the tax return by hand and mailing paper, relative burden of reporting may be a more important consideration - particularly if they expect to gain little or no tax advantage by de minimis exception on disposition/maturity. For example, my broker reports amortized bond premium in 1099-DIV and the amortized basis at disposition/maturity in 1099-B - so for such premium bonds, form 8949 is not needed to adjust basis for schedule D. Whereas for market discount bonds, accrued market discount at disposition is reported only in 1099-B - potentially leaving me to consider and split out any chosen dispositions eligible for the identify de minimis exceptions, and to omit the adjustments for those issues on form 8949 while transferring the sum of accrued market discount for the others to an adjustment line on Schedule B. But I'm actually in a high-taxing state that offers no preferred rate for LT CG, so TBH my stapler and I profit nothing from this added burden of 8949 reporting and we'd have reduced our workloads using small-premium acquisitions, had they been abundant when I was shopping.
Does personal tax software properly treat de minimis market discount opportunities, or offer the user a way to flag the eligible dispositions for preferred-LTCG-rate treatment of accrued discount, or to overrule against such treatment owing to state tax considerations? I have no idea. But I suspect even the worst ones do flow and sum ABP info from various 1099-DIVs to a single ABP adjustment line on Schedule B.

ETA: On review (from pub 550) it appears that treatment of de mimimis market discount accrual as CG may now be obligatory - not optional, as it is for de minimis OID. Hence I've struck through wording implying that one has an option in the matter, and added bolded substitutions/augmentations. [Those in high-taxing states may want to avoid buying treasuries at de minimis market discount in consequence.]
Last edited by ofckrupke on Fri Feb 14, 2020 6:24 pm, edited 2 times in total.

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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by #Cruncher » Fri Feb 14, 2020 5:12 pm

lgs88 wrote:
Fri Feb 14, 2020 1:25 pm
Does that different coupon have any tax consequences -- e.g., will I pay more in taxes over the life of the bond with the higher coupon?
The amount of tax may be different, but the after tax return should be the same. This is illustrated below using Wiggums's example of two 5-year bonds both yielding 5%, one with a 2% coupon and the other with a 4% coupon. Both bonds will sell at a discount. Each year the owner will pay tax on the coupon plus the accretion of principal value. More tax will be paid on the 4% coupon bond. ($5.84 versus $5.52 per $100 of face value with a 24% tax rate.) But the two right hand columns show that both bonds will have an after tax return equal to the pretax yield times 1 minus the tax rate (3.80% = 5% X 76%).

Code: Select all

Face value   100.00 
     Yield    5.00% 
     Years        5 
    Coupon    2.00%    4.00%    2.00%    4.00%    2.00%    4.00%    2.00%    4.00% 
     Price   87.01%   95.67% 
      Year   -- Cash  Flow --   Accreted Value     -- 24% Tax --   -- After Tax --
         0   (87.01)  (95.67)   87.01    95.67                     (87.01)  (95.67)
         1     2.00     4.00    89.36    96.45     1.04     1.15     0.96     2.85 
         2     2.00     4.00    91.83    97.28     1.07     1.16     0.93     2.84 
         3     2.00     4.00    94.42    98.14     1.10     1.17     0.90     2.83 
         4     2.00     4.00    97.14    99.05     1.13     1.18     0.87     2.82 
         5   102.00   104.00   100.00   100.00     1.17     1.19   100.83   102.81 
 Sum / IRR    22.99    24.33                       5.52     5.84    3.80%    3.80%
Notes:
  • Price and accreted value calculated with Excel PV function. For example, assuming annual interest payments for simplicity:
    87.01% = -PV(5%, 5, 2%, 1, 0) -- price of 2% bond
    89.36 = -PV(5%, 4, 2, 100, 0) -- value of 2% bond after one year
  • Tax calculated on sum of coupon and accreted value. For example:
    1.04 = 24% * (2.00 + 89.36 - 87.01) -- first year tax on 2% bond
  • After tax return calculated with Excel IRR function.
    3.80% = IRR({-87.01,0.96,0.93,0.90,0.87,100.83}) -- 2% bond
    3.80% = IRR({-95.67,2.85,2.84,2.83,2.82,102.81}) -- 4% bond
The same is true for premium bonds. Here is the same example of the 2% and 4% coupon bonds, but now with a 1% yield instead of 5%:

Code: Select all

Face value   100.00 
     Yield    1.00% 
     Years        5 
    Coupon    2.00%    4.00%    2.00%    4.00%    2.00%    4.00%    2.00%    4.00% 
     Price  104.85%  114.56% 
      Year   -- Cash  Flow --  Amortized Value     -- 24% Tax --   -- After Tax --
         0  (104.85) (114.56)  104.85   114.56                    (104.85) (114.56)
         1     2.00     4.00   103.90   111.71     0.25     0.27     1.75     3.73 
         2     2.00     4.00   102.94   108.82     0.25     0.27     1.75     3.73 
         3     2.00     4.00   101.97   105.91     0.25     0.26     1.75     3.74 
         4     2.00     4.00   100.99   102.97     0.24     0.25     1.76     3.75 
         5   102.00   104.00   100.00   100.00     0.24     0.25   101.76   103.75 
 Sum / IRR     5.15     5.44                       1.24     1.31    0.76%    0.76%
GrowthSeeker wrote:
Fri Feb 14, 2020 4:53 pm
... I assume that if you buy at discount then hold to maturity, you’d have a capital gain ...
The IRS taxes the discount as interest income, not as a capital gain.

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lgs88
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Re: Does it matter whether I buy low-coupon or high-coupon Treasuries?

Post by lgs88 » Fri Feb 14, 2020 5:43 pm

#Cruncher wrote:
Fri Feb 14, 2020 5:12 pm
...The IRS taxes the discount as interest income, not as a capital gain.
Ahh -- that's the trick! Thank you for laying that out for me. I had thought that had I purchased a bond at a discount and held it until it paid out at par at maturity, that gain would have been taxable as LTCG rather than interest income. I was wrong, and thus the confusion arose.

Thanks Bogleheads! The investment philosophy may be uncomplicated, but there are evidently a lot of big brains who ascribe to it.
merely an interested amateur

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