Tax-Efficient Trading of Municipal Bonds
Although tax-loss selling is widely recognized as a potential enhancer of after-tax return, it is usually employed opportunistically, rather than as part of a comprehensive investment strategy. In particular, little attention is paid to determining the optimum time to execute, given transaction costs.
Municipal bonds provide an ideal asset class to appreciate the benefit of active tax management, because the tax-exemption of interest by itself does not guarantee tax-efficient performance. We will present a dynamic approach to maximize after-tax return, which includes structuring of the portfolio and optimizing the timing of trades. The key insight is that the right to make a tax-driven trade is a (tax) option, which is acquired automatically and at no cost with any purchase. The value of this option can be rigorously determined. Selling and reinvesting entails swapping the associated options. Thus the sale decision should factor in the net loss of option value. Our dynamic strategy is expected to improve after-tax return over buy-and-hold by 30-80 basis points annually, depending on the duration of the portfolio and on investor-specific considerations. The approach can be adapted to other asset classes, including common equity.
Biography
Andrew Kalotay is a leading authority on the valuation of bonds and interest rate derivatives. He is a prolific contributor to the literature on topics ranging from advance refunding to tax-neutral valuation and tax management of municipal bond investments. His firm licenses fixed income valuation software and provides debt management advisory services.
Before establishing Andrew Kalotay Associates in 1990, Dr. Kalotay was with Salomon Brothers. Prior to Wall Street, he was at Bell Laboratories and AT&T. On the academic side, he was the founding director of the graduate Financial Engineering program at Polytechnic University (now part of NYU).
Dr. Kalotay holds a B.Sc. and M.Sc. from Queen's University and a Ph.D. from the University of Toronto, all in mathematics. He was inducted into the Fixed Income Analyst Society’s "Hall of Fame" in 1997.
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