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The Journal of Portfolio Management

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

Andrew Kalotay
The Journal of Portfolio Management Fall 2018, 45 (1) 118-124; DOI: https://doi.org/10.3905/jpm.2018.45.1.118
Andrew Kalotay
is president of Andrew Kalotay Associates, Inc.,in New York, NY
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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.

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The Journal of Portfolio Management: 45 (1)
The Journal of Portfolio Management
Vol. 45, Issue 1
Fall 2018
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Tax Optimization of Municipal Bond Portfolios: Investment Selection and Tax Rate Arbitrage
Andrew Kalotay
The Journal of Portfolio Management Oct 2018, 45 (1) 118-124; DOI: 10.3905/jpm.2018.45.1.118

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Tax Optimization of Municipal Bond Portfolios: Investment Selection and Tax Rate Arbitrage
Andrew Kalotay
The Journal of Portfolio Management Oct 2018, 45 (1) 118-124; DOI: 10.3905/jpm.2018.45.1.118
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  • Article
    • Abstract
    • TAX CONSIDERATIONS
    • DETERMINING HOLD VALUE
    • TAX RATE ARBITRAGE
    • THE TAX OPTION
    • CONCLUSION
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