In “The True Worth of Your Muni Portfolio,” I thought of alternative routes of quantifying the investor-specific worth of a taxable portfolio. The market worth just isn’t appropriate, as a result of liquidating the portfolio would have tax penalties, and due to this fact the liquidation worth can be completely different from the market worth. As a substitute of the market worth, I really useful the “tax-smart” worth, which is the larger of the safety’s after-tax sale worth and maintain worth.

Let’s calculate the tax-smart worth of a 10-year 5% bond bought two years in the past on the worth of 113.3, whose present tax foundation is 111. Right this moment, with eight years remaining to maturity, the market worth is 106. Sale at 106 would produce a 5-point long-term capital loss and due to this fact a 1-point tax saving at a 20% tax price, leading to after-tax proceeds from sale of 107. This exceeds the 106 maintain worth, and due to this fact right now the tax-smart worth is 107.

Do you have to promote this bond at 106 and notice the 5-point loss, or do you have to proceed holding it?

There are two funding methods: promote and reinvest, or do nothing. In case of a sale, the after-tax proceeds are reinvested in a like 5% 8-year bond, thus the par quantity of your holding would enhance by an element 107/106.

Let’s calculate the tax-smart efficiency of the 2 methods one 12 months later, below two situations. What if charges decline and the value will increase from 106 to 110? What if the value drops to 102?

The tax-smart portfolio values equivalent to the 2 methods are proven within the accompanying tables. Notice that the tax foundation relies on the technique: Beneath the do-nothing technique, primarily based on the unique 113.3 buy worth, it’s 109.782. Beneath the promote and repurchase at 106 technique, it’s 105.352, and the notional quantity of the funding has elevated by an element 107/106. The tax-smart returns, as measured by IRR, rely upon the terminal tax-smart portfolio values and the coupon curiosity obtained in the course of the 12 months.

State of affairs 1: Worth Rises to 110 in Yr 3

If the value will increase to 110, the return primarily based on sale in Yr 2 is 8.414%, and with out sale it’s 7.426%. The roughly 1% distinction is as a result of alternative price of not recognizing the capital loss on the finish of Yr 2 — as soon as the value will increase, such alternative could also be misplaced endlessly.

State of affairs 2: Worth Falls to 102 in Yr 3

If the value declines to 102, the efficiency of the tax-loss promoting technique continues to be barely higher: 1.589% vs. 1.466%. The distinction is partly attributable to the larger curiosity revenue from reinvestment below the tax-loss promoting technique, and it additionally relies on the amortization of the premise equivalent to completely different buy costs.

Realizing a loss and reinvesting has a further profit: It restarts the short-term clock. Lengthy-term losses are deductible at 20%. Brief-term losses, or these incurred in lower than one 12 months, may be deducted on the a lot increased price of 40%, offered that there are offsetting short-term good points. Assuming such is the case, if the market worth declines to 102, the three.384 loss (106.346-102.962) would end in 1.354 tax financial savings. The tax-smart terminal worth would enhance to 104.316, and the return to 2.223%, from 1.589%.

In abstract, tax-smart portfolio valuation alerts alternatives to enhance after-tax efficiency by recognizing losses. It pinpoints promoting alternatives by evaluating after-tax proceeds from sale to carry worth. Sale and reinvestment is especially efficient if the value subsequently improves, as a result of alternative price related to staying idle. If the value subsequently declines, restarting the short-term clock offers a possibility to acknowledge short-term losses at a excessive efficient tax price, additional enhancing efficiency relative to doing nothing.

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All posts are the opinion of the creator. As such, they shouldn’t be construed as funding recommendation, nor do the opinions expressed essentially mirror the views of CFA Institute or the creator’s employer.

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Andrew Kalotay

Andrew Kalotay is a number one authority on the valuation and administration of municipal bonds. His latest focus has been on maximizing the after-tax efficiency of individually managed accounts by dynamic funding and gross sales methods. His agency’s fixed-income analytics are utilized by main asset managers and risk-management platforms. Earlier than establishing Andrew Kalotay Associates in 1990, Kalotay was with Salomon Brothers. Previous to Wall Road, he was at Bell Laboratories and AT&T. On the educational aspect, he was the founding director of the graduate monetary engineering program at Polytechnic College (now a part of New York College). He’s a co-author of the CFA Degree II studying, Mounted-Earnings Evaluation. Kalotay holds a BS and MS diploma from Queen’s College and a PhD from the College of Toronto, all in arithmetic. He was inducted into the Mounted-Earnings Analyst Society’s “Corridor of Fame” in 1997.