Making Sense of Make-Whole Calls

Making Sense of Make-Whole Calls

If you’re involved with your institution’s investment portfolio, you’re likely familiar with callable bonds.  Typically, they are securities containing an embedded call option that gives the issuer the right to redeem the bond before its maturity date, paying the principal back early to the investor. 

But if you invest in municipal or corporate bonds, you may also come across bonds with a make-whole call.  It’s similar to a regular call structure that allows the issuer to redeem the bond before maturity. 

Unlike standard calls that only repay the principal amount, make-whole calls go a step further by compensating investors for the entire present value of expected future cash flows, including both principal and interest payments.

Picture this: if a make-whole call is exercised, the issuer ensures investors are ‘made whole’ by redeeming the bond before maturity and reimbursing them for all the money they would have received had the bond reached its scheduled maturity date.

How a Make-Whole Call Works

When a make-whole call is exercised, the issuer calculates the present value of the remaining cash flows associated with the bond, including both principal and interest payments. This value is determined using a predefined discount rate or a market-based formula. The issuer compares this amount to the bond’s par value and pays the higher of the two to the investor.

Another difference between a make-whole call and a standard call structure is when the call can be exercised.  With a traditional call structure, the bond can only be called after a specific date, known as the lockout period.  However, a make-whole call can be exercised anytime during the bond’s lifetime after it’s issued.

Benefits for Investors

Generally, a bond featuring a make-whole call provision can be advantageous for investors, as they tend to receive compensation greater than the par amount when the call is exercised.  This becomes especially beneficial when interest rates are falling, providing a little additional offset against the lower reinvestment rate on a replacement bond.

However, it’s worth noting that while issuers may incorporate a make-whole provision in a bond, history shows that make-whole calls are rarely exercised because of the higher compensation cost for the issuer.  Because of that, an investor has to consider the possibility that the bond won’t be called and will be held to maturity instead.  In addition, the yield on a bond with a make-whole call is usually slightly lower than other call structures because of the make-whole benefit.

Make-whole calls aren’t as prevalent as a traditional call structure.  Where you’ll most likely run into them is with corporate issues and the occasional municipal bond.  But it’s good to be aware of them and understand how they work because they may present an interesting investment opportunity.

Muni Investors: Watch Out for the De Minimus Rule!

Muni Investors: Watch Out for the De Minimus Rule!

If you are an investor in tax-exempt municipal bonds, I want to make you aware of a tax rule that has become important again after not being a factor for many years.  It’s called the de minimis tax rule, and it can result in an investor having to pay income tax rates on muni bond price appreciation.  This rule is especially important now with so many municipal bonds trading at deep discount prices because of the rising interest rate environment.

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What is the De Minimis Rule?

With tax-exempt munis, the income received is not taxable at the Federal level, and possibly at the state level as well.  However, the price appreciation is taxable if you pay below par for a muni bond. 

Usually, the appreciation amount would be taxable at the prevailing capital gains tax rate.  However, there may be circumstances where the price appreciation is taxed at current income tax rates instead.  That’s where the de minimis rule comes into play.  The de minimis tax rule determines whether the price appreciation of a municipal bond purchased at a discount is taxed as a capital gain or income. 

Calculating the Threshold Price

To determine whether the rule applies, we need to calculate the de minimis threshold price.  To calculate the threshold price, we simply multiply the years until the bond’s maturity by 0.25%.  Then, we subtract that number from par, or 100, which gives us the threshold price. 

For example, if we have a five-year tax-exempt muni, we multiply 0.25% by 5 to get 1.25%.  If we subtract 1.25 from 100, we get 98.75, which is the threshold price. 

Calculating the De Minimis Threshold Price

The one exception to this formula is when a bond is issued at a price below par, otherwise known as an “original issue discount.”  In that case, we’d subtract the amount we calculate from the discounted price instead of par.  So if a muni bond was originally issued at a price of 98, we’d subtract the amount we calculated (number of years to maturity times 0.25%) from 98 instead of 100.

How to Determine the De Minimis Impact

Once we know the threshold price, how do we use it?  If you purchase a tax-exempt muni bond at a discount, and that discount is above the threshold price, then the accretion of that discount will be taxed at the capital gains tax rate if the investor holds the investment for more than one year. 

On the other hand, if the discount price is below the threshold price, then the entire price accretion from the purchase price to par would be taxed at the ordinary income tax rate.

The De Minimis Rule & Deeply Discounted Bonds

Buying a deeply discounted tax-exempt municipal bond can create a greater tax impact, with the degree of impact depending on the investor’s income tax rate.  This is especially true for S-corp banks, where the income passes through to shareholders at their respective individual tax rates, which can be much higher than the corporate income tax rate paid by C-corp institutions.

So why is this tax rule back on the front burner again?  With the significant increase in interest rates over the past few months, and given the inverse relationship between interest rates and bond prices, many existing municipal bonds are trading at discounts. 

Given the large shift in interest rates, bond prices have fallen sharply, with some bonds trading at prices in the 80s and low 90s.  That puts the discounts well below the threshold prices determined by the de minimis rule. 

When such a situation occurs, as we’ve seen over the past couple of months, it can affect the muni market in several ways.  First, it can cause the number of buyers to dry up as they become less interested in muni bonds with deep discounts, given the higher tax impact.  Those buyers that stick around tend to desire a better price to compensate them for the effect of the de minimis tax rule.  That means they’ll want a lower price to produce a higher overall after-tax return that offsets the higher capital gains tax rate.

What If You’re Holding Muni Bonds?

What does all this mean for community bank investors holding tax-exempt municipal bonds with deep discounts?  First, the liquidity for these bonds has become much lower.  With less liquidity, pricing becomes sloppier, and bids typically become lower. 

I know of bankers that tried to sell positions after rates rose and were surprised by how low the bids they received were.  The prices were driven by the lack of buyers, as well as bond traders bidding a little wide to provide some wiggle room in the volatile market. 

In addition, the lower liquidity and required lower prices from buyers to offset the higher tax impact caused tax-exempt muni bond prices to drop further.  It caught some investors off guard, as a sudden whoosh in prices happened after prices had already declined in the higher rate environment. 

If your bank is holding muni bonds now trading at deep discounts, it’s important to understand that pricing could continue to be messy for a while.  Unless you need to liquidate a position, you may need to sit tight, at least for now.

What If You’re Buying Muni Bonds?

What about if you’re buying tax-exempt munis?  Then, it’s essential to keep in mind the de minimis tax rule and the threshold price calculation.  Remember, any municipal bond purchased at a discount below the threshold price will have its price accretion taxed at ordinary income tax rates. 

One way to manage the price is to buy municipal bonds with higher coupon rates.  To the degree that you can find them, the higher coupon rate will provide a little bit of a cushion and result in a higher price that may be above the de minimis threshold price.  Keep in mind that the shorter the bond’s maturity, the closer that discount would need to be to par.

Bloomberg Resources for De Minimis Rule Questions

Bloomberg has a couple of resources that help make sure you know how a discount bond will be treated under the de minimis tax rules.  The first resource is a Bloomberg quick reference known as QTAX, which will provide the threshold cutoff price for the de minimis rule.  QTAX will tell you what that price level is so you know where a bond’s price would be in comparison. 

In addition, Bloomberg’s FTAX screen will give you detailed Federal tax information on a tax-exempt municipal bond.  After you enter purchase and maturity information on a bond, the FTAX screen provides a breakout of the tax treatment, including whether the price accretion is taxable as a capital gain or ordinary income. 

If you don’t have access to a Bloomberg, your broker can run the screen and grab a copy for you.  It’s good information to have if you’re in the market for tax-exempt muni bonds trading at discounts.

Of course, I would be remiss if I didn’t mention that you should check with your tax accountant if you need more formal guidance.  I’m not a tax advisor, and I don’t play one on TV, so please make sure you check with the experts if needed beforehand.

Understanding the de minimus tax rule and how it operates is essential for investors in tax-exempt municipal bonds.  It can help ensure you don’t pay any unexpected income taxes on bonds you purchase at a discount, especially in the current rate environment.

3 Ways to Boost Your Muni Bond Due Diligence

3 Ways to Boost Your Muni Bond Due Diligence

As an investment portfolio manager, I recall the “good old days” when muni bond due diligence was so much easier. You made a few calls to the bond dealers and maybe checked out available bonds on the Bloomberg terminal.  Then you looked for bonds with decent credit ratings. Or better still, you sought out muni bonds that were insured.  By making a promise to back the bond issuer in the event of a default, the monoline insurance companies were able to deliver a solid AAA credit rating.  Once you found the bonds that worked, you executed your purchase trades and moved on to other things.

Boy, how times have changed.  In 2008, insurance companies such as AMBAC, MBIA, and FGIC got into financial trouble due to bad bets made on mortgage-backed and asset-backed securities.  This ultimately culminated in the monoline insurers being downgraded by rating agencies such as Standard & Poors, Moody’s, and Fitch. This resulted in the loss of the insurance companies’ coveted AAA status.  While the credit ratings of municipal bond issuers were still considered acceptable and default risk remained extremely low overall, the loss of the “easy AAA” made it a little more difficult for bond investors.

The Dodd-Frank Effect

Things got tougher in 2012 when rules stemming from the Dodd-Frank Act went into effect.  As described by the Office of the Comptroller of the Currency (OCC), Section 939A of Dodd-Frank amended the definition of “investment grade bonds” to eliminate any reference to agency credit ratings.  According to the OCC guidelines (which were adopted by other regulatory agencies):

“Under the revised regulations, to determine whether a security is “investment grade,” banks must determine that the probability of default by the obligor is low and the full and timely repayment of principal and interest is expected. To comply with the new standard, banks may not rely exclusively on external credit ratings, but they may continue to use such ratings as part of their determinations.”

The guidelines also require financial institutions to “supplement any consideration of external ratings with due diligence processes and additional analyses that are appropriate for the institution’s risk profile and for the size and complexity of the instrument.”  In short, this means that banks cannot point exclusively to bond credit ratings to justify a bond’s creditworthiness. They need to have a process in place to demonstrate adequate due diligence of their bond purchases.

Ways to Enhance Your Muni Due Diligence

While setting up a system to meet the rules does take some work, it is not difficult.  Here are three things you can do to provide a boost to your due diligence efforts:

1. Maintain document files for bond issuers

Keeping the official statement (OS) and the continuing disclosures from the issuers of bonds you own is a good start.  Bond dealers should able to provide these if you ask.  You can also get PDF copies of the documents online in some cases (see below).  If you have access to a Bloomberg terminal, you can also download issuer documentation.

2. Ask your bond dealers about available due diligence information

Many bond dealers can provide due diligence “snapshots” of municipal bond issuers.  When you are evaluating a municipal bond for purchase, ask them for a copy of any information they have available.

3. Use third-party online resources

In addition to materials available from your bond dealer, you can obtain useful information from online sources.  Some of these include:

EMMA – The Municipal Securities Rulemaking Board’s (MSRB) site, which is a repository of municipal bond documentation available in PDF format (you can learn more about EMMA on my resources page)

City-Data – Demographic and economic data on individual towns and school districts

State & Local Government on the Net – An online directory of state, county, and local government websites

MuniNet – A compilation of reports, news, and data pertaining to municipal governments

Your muni bond due diligence efforts are a necessary part of the process, but it does not need to be an obstacle.  Make these three steps part of your routine. Doing so will help you gain a better understanding of your portfolio holdings while providing a level of bond analysis that the regulatory guidance suggests.