The authors seek to quantify the value of the embedded tax option in municipal
bonds—the difference between a bond’s value under optimal tax management and
its value under the unmanaged buy-and-hold base case. They determine that under realistic
assumptions, the tax option embedded in a long-term bond has a value of several basis
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.
How Is This Research Useful to Practitioners?
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
How Did the Authors Conduct This Research?
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