Discount municipal bonds are much more sensitive to interest rates than reported by standard analytics systems. Investors who rely on these analytics will be in for an unpleasant surprise when rates rise.
During recent years of historically low interest rates, with most municipal bonds trading at a premium, investors have paid little attention to the adverse effect of taxes on the prices of discount bonds. As a result, investors have neither seriously challenged, nor required Currently Used Platforms (CUPs) to provide correct interest rate risk measures for bonds trading near or below par. The reality is that CUPs grossly underestimate the effect of rising rates.
Although interest is tax-exempt, the gain resulting from purchasing a muni at a deep discount - below the so-called de minimis threshold - is subject to severe tax treatment. It is taxed as ordinary income at maturity at a rate of about 40% for the typical investor. Thus, purchasing a bond at 80 would trigger an 8-point tax liability and cost the investor 3.2% of par at maturity.
We analyzed a portfolio of 185 munis which currently trade near par. After shocking interest rates up by 100 basis points, predictably the prices fall below par. However, as calculated by CUPs, the prices don't fall far enough. They are hugely overestimated, by over 3 points in many cases. The source of the problem is that CUPs disregard the tax payable on the discount at maturity, which depresses the prices further, as correctly calculated by MuniOAS, or option adjusted spread on municipals
Let's review the results for Bond #1 (Tempe, AZ) shown in the table. The current price of this bond is 99.20. The corresponding pre-tax and after-tax YTM's are 3.080% and 3.069% respectively. The after-tax YTM is lower due to the tax at maturity on the 0.80 point gain. According to the CUPs, a 100 bps increase of the yield curve would reduce the price to 89.33 (pretax YTM 4.127%). However, the corresponding after-tax YTM would be 3.828%, which is only 76 bps higher than the original YTM - recall that the rates were assumed to have increased by 100 bps.
In contrast, according to MuniOAS the price would decline to 86.10 (pretax YTM 4.499%, after-tax YTM 4.108%). Thus according to MuniOAS the after-tax yield would increase by 104 bps, roughly as expected.
As indicated in the table, the difference between the CUPs price and the MuniOAS price is 89.33-86.10=3.23 points. In other words, CUPs are reporting materially misleading results when calculating the effect of rising rates on discount munis.
