Journal Of Investment Management, Vol. 12, No. 1, (2014), pp.

62–68
© JOIM 2014
JOIM
www.joim.com

THE INTEREST RATE SENSITIVITY OF TAX-EXEMPT

BONDS UNDER TAX-NEUTRAL VALUATION
Andrew Kalotaya

We explore the effect of taxes on the prices of municipal bonds. Although interest is tax-
exempt, the gain resulting from purchasing a muni at a deep discount—below the so-called
de minimis threshold—is subject to severe tax treatment. The gain is taxed as ordinary
income at maturity; currently for a typical investor the applicable rate is roughly 40%.
Thus, purchasing a bond at 80 would trigger an 8-point tax liability.
The paper develops a rigorous approach to the pricing of munis by incorporating taxes
into the industry-standard OAS-based valuation framework. The key concept is ‘tax-neutral
value’, which is simply the fair value that takes into account potential tax payments. Tax-
neutral valuation allows us to explore how muni prices respond to changing interest rates.
The basic insight is that due to the interaction of the purchase price and the related tax
payment, discount tax-exempt bonds are significantly more sensitive to interest rates than
taxable bonds. For example, currently the duration of a 10-year taxable bond is roughly
8.5 years, while that of a 10-year muni can exceed 13 years.
Tax-neutral valuation provides the foundation for accurately projecting the prices of
munis under various interest rate scenarios. The primary application of this approach is
risk management, including hedging. It is also essential for determining the optimum time
to recognize a loss in order to maximize after-tax performance.

1 Introduction capital gains and losses are subject to complex tax

While interest payments on municipal bonds
(‘munis’) are exempt from federal income taxes,
a President, Andrew Kalotay Associates, Inc., 61 Broadway,
Suite 1400, New York, NY 10006, USA. Tel.: (212) 482
0900; E-mail: andy@kalotay.com
treatment. Taxes affect investors’ after-tax per-
formance. For example, because the gain on a
bond purchased in the secondary market at a dis-
count and held to maturity is subject to taxes,
the after-tax yield of the investment will be lower
than the pretax yield. The prices of discount tax-
exempt bonds are routinely converted to so-called

62 First Quarter 2014

 The Interest Rate Sensitivity of Tax-Exempt Bonds under Tax-Neutral Valuation
after-tax cashflow yields to maturity. Converting
price to an after-tax yield is straightforward,
and it allows investors to compare alternative
investments on an-apples-to-apples basis.
The prices of tax-exempt bonds reflect these com-
plex tax considerations. This phenomenon is well
recognized by practitioners but their attempts to
deal with the effects analytically have been lim-
ited to using yields and modified durations, and
not contemporary fixed income analytics (e.g. see
Leibowitz, 1981; Merrill Lynch, 2007). In this
paper we will extend the conventional arbitrage-
free method of bond valuation (the so-called
option-adjusted spread approach) to incorporate
tax effects. We first determine the tax-neutral
(‘fair’) value of a bond assuming a buy-and-hold
policy. This fair value provides the basis for rigor-
ous risk analysis.1 As we shall see, the interest rate
sensitivity of a muni can be significantly greater
than that of a like taxable bond.
The implications of this observation are far-
reaching. At the present, standard commercially
available analytical systems do not take taxes into
account. This is particularly troublesome in the
case of exchange traded funds and mutual funds
that attempt to replicate the performance of a
large index—which may consist of over 10,000
bonds—with a few hundred securities. Matching
durations on a pretax basis does not assure that
the same relationship holds when the effect of
taxes is properly accounted for. In light of this,
the large tracking errors of these ‘index-matching’
portfolios do not come as a surprise.
2 Relevant tax treatment
A thorough discussion of the tax treatment of
munis, including original issue discount bonds
(OIDs) and original issue premium bonds (OIPs),
is provided by Ang et al. (2010). For illustrative
purposes, we will assume that the bonds under
consideration were originally sold at par.
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63
Investors who purchase a bond in the secondary
market at a discount and hold it to maturity or call
are taxed on the gain. At a modest discount to par
(a so-called de minimis discount, defined as less
than 0.25 times the number of years remaining to
maturity) the applicable rate is the relatively low
capital gains rate (at the time of writing, 20% if
long-term). If the discount exceeds the de minimis
threshold, the entire gain is taxed at the higher
ordinary income rate (around 40% at the time of
writing). We also note that the loss on a bond
purchased at a premium and held to maturity has
no tax effect.
The tax treatment is more complicated if the bond
is sold prior to maturity or call. But because the
values in the current discussion are based on buy-
and-hold, we ignore taxation related to sales.
3 Market prices of munis
The obvious first question to explore is the rea-
sonableness of the assumption that market prices
can be imputed from a buy-and-hold strategy. On
the one hand, Constantinides and Ingersoll (1984)
argue that active tax management can produce
superior return over buy-and-hold. This would
imply that market prices should be higher than
that indicated by buy-and-hold. On the other hand,
there is scant empirical evidence that such is the
case. In fact, according to Ang et al. (2010),
the market prices of deep discount munis are
significantly lower than would be implied by buy-
and-hold, and they provide a possible explanation
for this phenomenon.
In any case, for risk management purposes it is
irrelevant whether the actual prices are marginally
higher or lower than that indicated by buy-and-
hold. The relevant fact is that prices of munis do
reflect the presence of taxes, and our approach
could be readily adapted to pricing models more
sophisticated than ‘buy-and-hold’, should such
become available.
Journal Of Investment Management
64 Andrew Kalotay

4 Methodology the case of a callable bond the fair value has to

Our initial goal is to determine the tax-neutral
value (‘fair value’) of tax-exempt munis using
arbitrage-free analysis (see Kalotay et al. (1993)).
In the absence of taxes and options, fair value is
obtained by discounting prospective cash flows at
the appropriate spot rates; if options are present,
such discounting is performed on a lattice. The
taxation of munis complicates the calculation
because the cash flows depend on the purchase
price; roughly speaking, the lower the purchase
price the more taxes will be due when the bond is
retired.
4.1 Practical considerations
Arbitrage-free valuation requires an issuer-
specific optionless (par) yield curve for discount-
ing, and for valuing options at a specified interest
rate volatility. In the case of tax-exempt bonds,
optionless long-term rates are not readily avail-
able, because the industry-standard MMD and
MMA yield curves assume that the underly-
ing bonds are callable at par after 10 years.
The approach of extracting optionless par curves
from callable curves is described in Kalotay and
Dorigan (2008). The numerical examples below
assume that the optionless curve has been pro-
vided and that it evolves according to an industry-
standard lognormal process. Our methodology,
of course, is applicable to arbitrary interest rate
processes.
be determined iteratively, as the timing of the
tax payment depends on the evolution of inter-
est rates. The calculation can be simplified if the
bond is optionless, as illustrated below.
Assume that the bond has 10 years remaining to
maturity, its pretax value is 80, the discount factor
for a cash flow occurring 10 years from now is
0.45, and the tax rate applicable to the gain is
40%. Solving
V = 80 − 0.45 × 0.40 × (100 − V )
gives the fair value V = 75.610.
Figure 1 displays the fair values of 10-year bonds
with various coupons. For comparison purposes,
we also show the values in the absence of taxes.
The calculations are based on the yield curve
displayed in Table 1. The assumed volatility for
callable bonds (see Figure 3) is 20%. The long-
term capital gains rate is 20%, and the tax rate
applicable to ordinary income is 40%.
Note that the pretax value of a discount muni
exceeds its fair value by the present value of
the taxes paid at the time the bond is redeemed.
(The discount rate applied to the tax payment is

5 Tax-neutral value
We now determine the value of a bond under
the buy-and-hold strategy. We define the tax-
Figure 1 Fair value of 10-year bonds.
neutral (fair) value as the price which is equal
to the present value of after-tax cashflows (i.e.
interest and principal payments minus the taxes Table 1 Issuer’s optionless par yield curve.
paid at the time of redemption). Simply put, the
Maturity (yrs) 1 2 5 10 15 20 30
fair value is the ‘pretax’ value adjusted for taxes.
Rate (%) 1.0 1.5 2.0 3.0 3.5 4.0 4.5
Because taxes depend on the purchase price, in

Journal Of Investment Management First Quarter 2014

 The Interest Rate Sensitivity of Tax-Exempt Bonds under Tax-Neutral Valuation
the spot rate derived from the issuer’s yield curve.)
Here the de minimis threshold is 97.50% of par
(100 − 10 × 0.25). In the absence of taxes, a
bond with a 2.72% coupon would be valued at
97.50 (blue line), but due to the tax on the gain
the value would be less. Conspicuous in Figure 1
is how the fair value (red line) ‘falls off the cliff’
at the de minimis level. The ‘critical’ coupon (dis-
cussed below) is 2.76%. If the coupon is 2.75%,
the fair value declines by 0.60% to about 96.90.
The reason is that above 97.50 the gain is taxed
at the 20% capital gains rate, but below 97.50 the
gain is taxed at 40%.
The de minimis threshold with 30 years to matu-
rity is 92.50%. The critical coupon for a bullet is
4.10%; at 4.09% the fair value drops by 0.36%
to 92.14 (red line). The effect is less pronounced
than in Figure 1, because the maturity is farther
away. In the absence of taxes, a coupon of 4.07%
would give a 92.50% value (blue line).
As discussed above, it is more difficult to deter-
mine the fair value of a callable bond than that
of a bullet, because the redemption date is uncer-
tain and in turn so is the present value of the tax
payment. We also note that the redemption date
depends on the interest rate volatility (assumed to
be 20% in the illustration below). Thus in this case
the fair value must be calculated by lattice-based
recursion.
Figure 2 Fair value of 30-year bullets.
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65
Figure 3 Fair value of 30-year NC10’s.
In comparison to Figure 2, the presence of the call
option reduces both the pretax and after-tax val-
ues. In the case of lower-coupon bonds the results
are similar to those in Figure 2, because the effect
of the call option is relatively insignificant. In the
case of higher-coupon bonds the tax effect is rel-
atively insignificant to begin with, because the
price is closer to par.
5.1 Critical coupon level
As we saw in the examples above, for a given yield
curve and bond structure (i.e. maturity and option-
ality) there is a theoretical coupon level where the
fair value falls off the cliff. While in reality the
price decline is not as abrupt as indicated by our
model, this critical coupon level is still of prac-
tical interest. If a bond is purchased at a price
slightly above the de minimis threshold, its price
could decline significantly even if rates rise only
modestly. Because the market anticipates this pos-
sibility, the price experiences downward pressure
when the coupon is slightly above the critical
level. Similarly, the price can be higher than that
predicted by our model if the coupon is slightly
lower than the critical level. Price behavior near
the de minimis level is of independent interest and
could be explored as a separate study.
We also observe that while market prices are
extremely important to investors whose portfolios
Journal Of Investment Management
66 Andrew Kalotay
must be marked to market (such as mutual funds
and ETFs), they are less significant for buy-and-
hold investors. The point is that the value of the
remaining cashflows to an existing investor can be
higher or lower than to a marginal buyer. This is
discussed in Kalotay and Howard (forthcoming).
For a given yield curve, the critical coupon of an
optionless can be determined easily (see below).
For a callable bond the calculation is obviously
more complicated.
Illustration: Determining the Critical Coupon C
of an Optionless 10-Year Bond
Assume the present value of a 10-year $1 annuity
is $8.50, the discount factor for a cash flow occur-
ring 10 years from now is 0.70, and the capital
gains rate is 20%. Solving
8.50 × C + 0.70 × (100 − 0.20 × 2.50)
= 97.50,
results in C = 3.28%.
Note that the fair value of a bond whose coupon
is slightly below 3.28% is
97.50 − 0.70 × (0.40 − 0.20) × 2.50 = 97.15,
which accounts for the incremental tax bill arising
from the applicability of the ordinary income tax
rate (40%) over the tax bill arising from applying
the short-term gain rate (20%).
6 The interest rate sensitivity of
tax-exempt bonds
In the preceding sections of this paper we devel-
oped a tax-neutral valuation model for tax-exempt
bonds assuming buy-and-hold, and explored the
behavior of this model for various bond structures.
Given the above foundation, we are ready to inves-
tigate the interest rate sensitivity of tax-exempt
bonds.
Journal Of Investment Management
The general approach to determining interest rate
risk is as follows:
(1) Determine the OAS of the bond at the given
price relative to the benchmark yield curve.
(2) Shock the yield curve.
(3) Reprice the bond at the OAS obtained in (1).
(4) Calculate risk measures.
In the case of tax-exempt bonds, it is imperative
to recognize that the prices may be depressed by
potential tax payments; otherwise the interest rate
sensitivity can be severely underestimated. The
intuition is clear: higher rates depress the price,
and a lower price increases taxes. The OAS should
be an indication of only credit risk or mispricing,
but it should not reflect tax effects. The appro-
priate spread measure for munis is tax-neutral
OAS, that is, the OAS that equates the price to
the tax-neutral value.
Naturally the higher the applicable tax rate the
greater is the above effect, so it is most pro-
nounced when the price is below the de minimis
threshold. At the de minimis threshold the price
is discontinuous, and therefore interest rate sensi-
tivity is not defined. Whenever the tax treatment
is discontinuous it is desirable to distinguish
between ‘up’ and ‘down’ durations.
The exhibits below display the durations of vari-
ous tax-exempt bond structures using tax-neutral
prices (based on the benchmark curve).
Figure 4 displays the durations of 10-year
optionless bonds. As we saw in Figure 1, the
critical coupon in this case is 2.76%. The
durations of bonds with coupon below 2.76%
exceeds 12 years, which is 2 years longer
than the bonds’ maturity! Duration slightly
exceeds 10 years even in the de minimis
region (coupons larger than 2.76% but less than
3.00%).
Since the pretax duration of a bond cannot exceed
the bond’s maturity, any calculator that disregards
First Quarter 2014
 The Interest Rate Sensitivity of Tax-Exempt Bonds under Tax-Neutral Valuation
Figure 4 Duration of 10-year optionless bonds.
taxes will severely underestimate the true duration
of discount bonds. But the error is significant even
if the price is close to par—for example, the pretax
duration of a bond in the de minimis region is 8.85
years, considerably shorter than the true duration.
It is well known that taxes can have a drastic
effect on interest rate sensitivity. For example,
as pointed out by Kalotay (1984), the after-tax
duration of an original issue discount bond issued
by a taxable corporation can exceed the bond’s
maturity.
Figure 5 below shows similar information for 30-
year bonds callable in 10 years. As long as the
price is below par, the duration is longer than
it would be in the absence of taxes (latter not
shown). The duration is not defined when the price
is discontinuous—in this case when it declines
below par (slightly below a 5.00% coupon) and
Figure 5 Duration of 30NC10 bonds.
First Quarter 2014
67
again when it falls below 92.50 (the de min-
imis threshold price occurring at around a 4.33%
coupon).
There is an obvious extension to key rate durations
(not discussed here).
6.1 Observations about ‘pretax’
risk measures
As described at the beginning of this section, inter-
est rate risk measures are calculated using a fixed
OAS relative to a benchmark yield curve. Note
that OAS depends on whether or not tax effects
are incorporated.
Example: Solve for OAS, Calculate Duration
Suppose that the price of an optionless 10-year
2.5% bond is 84.15; calculate its OAS relative to
the benchmark curve given earlier.
Pretax (incorrect): OAS = 147 bps, dura-
tion = 8.87 years
Tax-neutral: OAS = 90 bps, duration = 12.14
years
Correct calculation of interest rate risk requires
an explicit adjustment for taxes. In the absence of
such, the risk of tax-exempt bonds is underesti-
mated.
7 Conclusion
It is generally recognized that taxes on capital
gains depress the prices of tax-exempt bonds. We
have presented a rigorous approach to incorpo-
rating this effect in the valuation of tax-exempt
bonds. Specifically, we extended the conventional
OAS framework to after-tax analysis, including
tax-neutral value and tax-neutral OAS.
Using tax-neutral values as a foundation, we have
shown that the interest rate sensitivity of tax-
exempt bonds can be significantly greater than
Journal Of Investment Management
68 Andrew Kalotay
that indicated by pretax calculation, which unfor-
tunately is the current standard in the industry. The
difference is most pronounced for shorter-term
bonds selling below the de minimis level, whose
duration can exceed their maturity by several
years.
In light of the fact that under current prac-
tice the interest rate sensitivity of tax-exempt
bonds is miscalculated, the large tracking errors
of ‘index-matched’ ETFs and mutual funds are
not surprising. Tax-adjusted analytics are essen-
tial for proper management of tax-exempt bond
portfolios.
Note
1 Tax-neutral values, durations, and other values in
this paper were calculated using Kalotay Analytics’
MuniOASTM library (patent pending).
References
Ang, A., Bhansali, V., and Xing, Y. (2010). “Taxes on Tax-
Exempt Bonds,” Journal of Finance 65(2), 565–601.
Journal Of Investment Management
Constantinides, G. M. and Ingersoll, J. E. (1984). “Optimal
Bond Trading with Personal Taxes,” Journal of Financial
Economics 13(3), 299–335.
Kalotay, A. (1984). “An Analysis of Original Issue Discount
Bonds,” Financial Management (Autumn), 29–38.
Kalotay, A. and Dorigan, M. (2008). “What Makes the
Municipal Yield Curve Rise,” Journal of Fixed Income
(Winter), 65–71.
Kalotay, A. and Howard, C. D. “The Tax Option in
Municipal Bonds,” Journal of Portfolio Management.
forthcoming.
Kalotay, A., Williams, G., and Fabozzi, F. (1993). “A Model
for Valuing Bonds and Embedded Options,” Financial
Analysts Journal (May/June), 34–46.
Leibowitz, M. (1981). “Volatility in Tax-Exempt Bonds: A
Theoretical Model,” Financial Analysts Journal (Novem-
ber/December).
Merrill Lynch (not an individual) (2007). “Dealing with
Deeper Discounts,” Muni & Derivatives Commentary
(June 18), 1–2.
Keywords: Municipal bonds; tax-neutral value;
taxes; duration; de minimis rule; bond valuation;
after-tax; interest rate sensitivity; risk manage-
ment; tax-neutral OAS; option-adjusted spread;
critical coupon
First Quarter 2014