It’s been a long time since bond reps at retail firms have had to worry about de minimis disclosure, the heads-up that buyers paying below the de minimis level will see their discount treated as ordinary income and not capital gain. That’s because a long bull market has made discount bonds very scarce.
But higher rates will bring them back, along with de minimis concerns. The difference this time is we have new analytics that correctly capture the increased downside risk due to de minimis, something that might potentially raise the bar on discount-bond disclosure.
Take the scenario of a retail client talking to her bond-desk rep. She’s looking for a bond no longer than 10 years, because she wants to avoid the bigger price swings of longer maturities. Her rep identifies two 10-year candidates: one trading above par and another lower-coupon bond trading at a small discount. She decides to go with the higher-yielding discount bond after the rep verifies “No, this discount isn’t subject to de minimis.”
A week later the Federal Reserve tightens, and the client sees that her bond drop nearly 40% more than the other one she had considered. Stunned at the difference, she contacts a money-manager friend to get an independent take on what happened.
The money manager explains, “Even though you’re not subject to de minimis tax treatment, you’re still subject to de minimis 'market' effects."
These effects are why institutional investors purchase bonds at big premiums, to keep them far above the de minimis whirlpool that occurs around par and pulls down prices much faster than you’d expect. Professionals tend to avoid bonds trading near par, and in fact some managers have an informal protocol of bailing out and selling once a bond moves down to 103.
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“You got caught in that downdraft. It’s a dreaded effect well known to institutional players, but you need specialized tools to get a proper handle on it. Your 10-year discount bond actually has a volatility that equates to a ’duration’ of about 13 years — longer than its maturity — versus about nine years for the 10-year premium one. Maturity is a rough guide to volatility, duration is a precise one.”
“Until recently the right tools weren’t widely available, but these days you could have been given a clear heads-up about that 40% difference in price movement you saw.”
And how does the bond-desk manager respond when the client complains that she got what amounts to a riskier 13-year bond when she specifically said no more than 10? “I’m sorry, but we don’t have the tools or training for that”?
It may take time before regulators take an interest in de minimis disclosure, although one could argue that there’s at least as good a case for this de minimis disclosure as there is for a credit-watch heads-up. After all, what’s more likely to happen over the next six months, that an issuer’s bond on credit watch will actually be downgraded, or that its discount bond will see an event that triggers the de minimis price slide?
Due to the recent increase of interest rates, de minimis risk has become a timely topic. Quoting from the February 11 BofA Municipals Weekly, "In January, high grade (near-par) 2s endured the most brunt of duration extension and de minimis risks… ."
It also observes that, "If a bond was already traded as a discount bond before the selloff … then during the selloff the loss would be no more than linear with rates… ."
True, but the interest rate sensitivity of a discount muni, as measured by its duration, will be significantly larger than that of a like-maturity bond trading at a premium.
Firms don’t have to see the disclosure of de minimis risk as a matter of compliance. They can see it as a chance to better inform their retail clients about an important liquidity risk, and to put them on the same footing as institutional players. Think of it as an educational initiative, not a regulatory one.
This commentary was co-written by my friend Paul Fennell,
