Tax cushion

Question: Why are most bonds in the muni market priced at a premium?

Ann Ferentino: So if you look at the Bloomberg Muni Bond Index, you're going to see that about 80% of the bonds are priced at a premium. Compare this to the Bloomberg Corporate Bond Index, and you only have about 20% that are priced at a premium. And to explain why that is, let's look at how the difference in terms of how muni bonds are issued relative to corporate bonds. First, let's look at corporate bonds. Corporate bonds are issued to be priced at par. That means that their coupon and yield are the same. So whatever yield you're getting on that bond, you're going to set the coupon at that same rate. As soon as the market yield diverges from the yield where that bond was priced, the bond is then going to trade at a premium, above par, or at a discount below, below par. In this rising interest rate environment that we've been in for some time, that's going to cause bonds to price at a discount. So it's no wonder that the corporate bond index is primarily discount bonds. Now, muni bonds are priced differently. They are priced with a conventional coupon, could be 5, 4, 3%. So munis are issued, the coupon is set, and then that price is determined based on the yield you receive on the bond. So if the yield is lower than the coupon rate, the bond is priced at a premium and most bonds are intentionally priced this way. Why is that? Because muni bonds are priced at a premium to protect against tax consequences that are the result of the de minimis rule. The IRS de minimis rule has to do with discounted bonds. An investor will often think that they want to buy a discount bond because they will then receive, not only the income on that bond, but that accretion from the discount price to par. However, if the discount is deep enough, they will have to pay ordinary income tax on that accretion to par. Now, for a taxable investor, they don't really care because they own a taxable investment. But for a muni investor or a tax-exempt investor, they do not want to pay taxes on their muni investments. So therefore, bonds are issued at a premium to protect against these bonds falling below this de minimis threshold.