Although interest on municipal bonds is exempt from federal income taxes, capital gains and losses are subject to complicated tax treatment. Investors may be able to benefit from this tax treatment by selling bonds whose price has sufficiently dropped and thus reduce their tax obligations. The value of the tax option depends on such market-related factors as the volatility of interest rates, bid–ask spreads, and the duration of the bond, in addition to the treatment of capital gains and losses.

This research is useful because the authors attempt to quantify the value of the tax option embedded in municipal bonds. Investors in tax-exempt bonds may be able to improve their after-tax performance by selling bonds that have experienced a sufficiently large loss in value. Under realistic assumptions, the value of this embedded tax option amounts to several basis points. The authors determine that increases in the bond’s maturity, in addition to tax rates, are a significant driver of the tax option’s value. A higher issue price also increases the value because the bond is likely to fall below its minimum threshold.

Moreover, greater interest rate volatility and lower transaction costs also increase an option’s value. For example, at a 20% interest rate volatility and 0.5% transaction cost, the embedded tax option provides roughly 6 bps in incremental annualized return. The same assumptions with a 30-year bond callable after 10 years, however, translate to approximately 35 bps of annualized incremental return. A relatively modest increase in market rates results in a large decline in the market value, thus creating an opportunity to sell the bond at a loss and reduce taxes. Therefore, short-term losses written off at a 40% tax rate can significantly increase an option’s value.

In summary, under realistic assumptions, a long-term bond’s embedded tax option is substantial, especially when the investor can offset short-term capital gains with short-term losses.

Federal tax rates significantly increased at the beginning of 2013 and may be subject to further changes. For this analysis, the authors use a long-term capital gain/loss tax rate of 20%, a short-term capital gain/loss tax rate of 40%, and an ordinary income tax rate of 40%. Their analytical approach extends conventional valuation based on option-adjusted spreads to include municipal bonds’ tax treatment.

The required inputs are a market-implied optionless par yield curve and an interest rate volatility that together determine rate evolution. The optimal option exercise requires investigating a lattice-based future and comparing the tradeoff between selling and waiting at each node. The numerical implementation is a recursive valuation of a path-dependent option. Under optimal management, the investor sells when the resulting benefit fully compensates the investor for the forfeited tax option’s value.

Moreover, a bond’s price in various future market environments is important to consider. The expected price is the fair value without taxes. The fair value of a municipal bond must incorporate the investor’s tax from capital gains. The tax-neutral values—defined as the fair, tax-adjusted values under buy and hold—provide convenient and defensible estimates of future prices. The authors define the tax-neutral value as the price equal to the present value of future inflows adjusted for the taxes paid on the gain at maturity or when the bond is called.

The authors provide great insight into the various characteristics of embedded tax options in municipal bonds. A detailed understanding of municipal bonds, as well as other investment vehicles, allows for improved asset management performance. It is critical for investment professionals to have a thorough understanding of these embedded tax options to maximize the performance of their portfolios. Ultimately, I hope further research expands on these findings in terms of how these options fit into the context of an overall investment portfolio strategy.