Joseph G. Mowrer III, BridgeTower Media Newswires
Municipal bond funds offer several advantages to individual bonds. One powerful yet little understood advantage has to do with amortizing bond premiums, and results in higher after tax returns for fund investors versus individual bond investors. And in today’s environment where low interest rates have lifted the prices of nearly all quality bonds to significant premiums, this becomes especially relevant. Here’s how it works.
Let’s assume the characteristics of a typical municipal bond that is trading today—a 5% coupon with a 10-year maturity at a price of $120.
Suppose an investor buys this bond directly and holds the bond until maturity. This investor is required to “amortize” the bond premium over the life of the bond. Similar to how a car’s value might depreciate, the bond premium is amortized until maturity. In this example, the cost basis of the bond would be reduced by $2 per year until maturity. Upon maturity, the cost basis and value of the bond would both be $100, and there would be no opportunity to realize a valuable capital loss.
Now let’s suppose this investor buys shares of a mutual fund that holds this bond (along with a basket of other similar characteristic bonds.) This investor would receive the same income and net total return from this bond. However, here’s the key difference. The mutual fund itself amortizes the bond premium over the life of the bond, not the investor. During the life of this bond, the net asset value (NAV) of shares of this mutual fund would decrease as a result of the fund’s amortization of this bond. Over time as professional bond fund managers buy and sell bonds in their portfolios, the benefit of this realized loss is disguised but becomes a component of the bond fund’s total return. Essentially, this process converts a capital loss into tax-free income for investors of the fund. The result is a higher annualized return versus an individual bond.
In addition to this benefit, bond funds also offer professional management, diversification, and access to better pricing than is available to individuals. Also, fund investors can realize capital gains and harvest losses by selling their shares while this may not be an option for individual bond holders. And to take it one step further, closed-end funds offer all these advantages plus the ability to buy shares at significant discounts. But don’t tell anyone or this secret may get out.
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Joseph G. Mowrer III is a Senior Tax-Sensitive Fixed Income Analyst for Karpus Investment Management, a local independent, registered investment adviser managing assets for individuals, corporations, non-profits and trustees.
