Tax Optimization of Municipal Bond Portfolios: Investment Selection and Tax Rate Arbitrage

Abstract

This article considers how to improve the after-tax performance of a municipal bond portfolio by using tax-beneficial selling strategies. These strategies include tax loss harvesting (selling a bond at a price below the investor’s tax basis), applicable when interest rates increase, and tax rate arbitrage (paying tax earlier at a relatively low long-term capital gains rate, rather than at maturity at a much higher rate), applicable when rates decline. A tax-beneficial selling opportunity is a free investor-specific option, acquired automatically at the time of purchase. The combination of tax loss harvesting and rate arbitrage opportunities provides a straddle. The embedded tax option in a portfolio can be valued using option-adjusted spread–based bond analytics. Astute investors should maximize the value of the tax option in their portfolios, subject to the usual portfolio profile constraints. The author shows that bonds purchased near par are poorly suited for tax management and that dynamic tax management can improve the expected annual after-tax return by 20 to 30 bps.