Par Munis: Sub-Par Performance

Abstract

It is well recognized that institutional municipal portfolio managers prefer premium bonds to those selling near par. This article shows that such aversion to par bonds is justified because they are expected to underperform comparable premium or discount bonds in the near term. The extent of the underperformance depends on the shape of the yield curve and is positively correlated with the level of expected interest rate volatility. The underperformance is attributable to tax considerations. When an investor purchases a municipal bond (muni) below par, the resulting gain is taxed at maturity, and the price is depressed by the present value of the tax. This tax effect amplifies the interest rate sensitivity of discount munis. Munis selling near par are also negatively convex; the potential decline attributable to higher interest rates exceeds the increase stemming from commensurately lower rates. The underperformance of near-par munis relative to those selling at a high premium (or at a deep discount) arises from the resulting combination of extended duration and negative convexity. The changing value of tax liabilities creates a unique challenge in determining interest rate sensitivity and expected return—which conventional analytics fail to recognize. The tax-neutral analytics used in this article not only incorporate the value of future tax costs but also provide an accurate method for predicting muni price changes and investment returns.

Key Findings

• ▪ Because of their negative convexity, municipal bonds (munis) selling near par perform poorly relative to comparable premium and discount bonds. Negative convexity arises from the so-called de minimis tax effect, which further depresses the price once it falls below par.

• ▪ The expected underperformance depends on the shape of the yield curve and the volatility of the interest rates. Portfolio managers whose performance is based on market prices should avoid par munis in favor of those selling at a high premium.

• ▪ Tax-neutral option-adjusted spread (OAS) technology is essential for the proper analysis of near-par munis; conventional OAS underestimates their duration and completely misses their negative convexity.