In a 2011 letter to a school district, California’s then-Attorney General Kamala Harris decried “the practice of artificially inflating the interest rate” to obtain “additional bond proceeds over and above what the voters authorized.” If only she had known that this practice is subsidized by the federal tax code!
This costly and seemingly inadvertent subsidy is discussed in my forthcoming paper titled Tax distortions and bond issue pricing. The paper does not contain any policy proposals, but in this companion article I propose a couple of ways to eliminate the subsidy.
The paper starts from the observation that bonds with large issue prices are very common in the tax-exempt market, and quite rare elsewhere:
The histogram of issue prices of U.S. Treasury bonds looks like a candlestick: all bonds are issued with a tiny discount to face value (if face value is normalized to 100, a typical list of auction prices will be 99.9, 99.75, 99.82, …).1 Corporate bond prices are equally boring. Taxable municipal bonds? A little more scattered, but still solidly anchored around 100.
And then there are tax-exempt municipal bonds. Tax-exempt munis are routinely issued at large premiums, i.e., with prices like 110, 115, 120. I will not keep up the suspense: issuing premium bonds is a form of tax arbitrage. Compared to the counterfactual of issuing bonds at par, the issuance of premium bonds costs the U.S. Treasury an estimated 1.7 billion dollars a year in lost revenue.2
The one weird trick I would suggest would be to disallow capital losses for tax-exempt bonds issued at premium, unless the price drops below par. For instance, if a bond is issued at 120 and the next day it’s sold at 95, the capital loss is not 120 – 95 = 25, but rather 100 – 95 = 5. The rationale for this approach should become clear soon. If this measure were adopted retroactively (i.e., if it were to apply to losses on bonds already in circulation), substantial savings would likely begin to be felt within the 10-year budget window, especially if interest rates rise. If retroactive adoption is not an option, savings would take longer to materialize, but they could perhaps still help down the road.
A simpler and less weird alternative would be to ban premium tax-exempt bonds altogether. The U.S. Treasury and for-profit corporations almost never issue premium bonds, and it would be easy to argue that there is no good business reason to issue them.3 In fact, the U.S. Treasury has banned premium municipal bonds in the past–except that the ban only applied to Build America Bonds, which are taxable.4 I personally do not recall the reason, but hey, there are many good reasons to ban premium bonds. (Some of them are described at the end of the article). A drawback of this approach, however, is that it cannot be made retroactive because the bonds already in circulation cannot be un-issued.
Premium tax-exempt bonds are tax-efficient
You might be wondering: “How can the Treasury lose revenue? These bonds are already tax-exempt! There is no tax revenue coming from them.” Your perplexity is understandable. It is correct that the Treasury expects zero revenue, but it is not correct to assume that it has nothing to lose. From premium tax-exempt bonds, the U.S. Treasury expects negative revenue.5
To see why, let’s begin by examining the case in which Alice and Bob buy two similar bonds issued at par (i.e., they pay 100 to the issuer). After a short amount of time ε the bond prices drop to 90. If Alice and Bob were to simply sit on their bonds until maturity, they would never realize any gain or loss, and because the interest from the bonds is tax-exempt, they would never pay any taxes.
Instead of sitting on their bonds, however, Alice and Bob agree to a taxable swap: each will sell their bond at a fair market value to the other. As a result, their portfolios will be practically unchanged, but both will have realized a capital loss of 10. Assume this loss is deductible at the capital gains tax rate of 20%, so that it generates an immediate benefit of 2. Upon maturity, having paid 90 for the bond, Alice and Bob receive 100 (the bond’s face value) and thereby realize a gain of 10. This gain is labeled “market discount gain” and it is taxed at the ordinary rate of 40%, so that it generates a cost of 4. The swap and its consequences are represented in the diagram below.
It is not clear whether Alice and Bob gained or lost from the swap. Is it better to never pay any tax, or is it better to get a tax rebate of 2 now, and then pay tax of 4 upon the bond’s maturity? It depends on the investors’ discount rate and on the amount of time until maturity. However, roughly speaking, it would take a very long time to maturity or a very high discount rate for Alice and Bob to be happy about the swap.
Now consider the same exact vignette, except that the bonds are premium bonds. They are issued at 110. At time ε, their price drops to 100. Alice and Bob do the swap and get an immediate benefit of 2. Upon maturity, having paid 100 for the bonds, Alice and Bob receive 100 (the bonds’ face value) and… that’s it. There is no gain or loss. Alice and Bob receive an upfront benefit of 2 from the U.S. Treasury, and never pay any taxes since. Hence, the negative revenue. This tax arbitrage scheme works for all premium bonds, regardless of discount rate and bond maturity.
This scheme is very common, so much so that it features on FINRA’s list of “smart bond investment strategies” [emphasis mine]:
Bond Swapping involves selling one bond and simultaneously purchasing another similar bond with the proceeds from the sale. Why would you engage in this practice? You may wish to take advantage of current market conditions (e.g., a change in interest rates), or perhaps a change in your own personal financial situation has now made a bond with a different tax status appealing. Bond swapping can also cause you to receive certain tax benefits. In fact, tax swapping is the most common of bond swaps.
Now it should be clear what the weird trick does: disallowing losses above par directly eliminates this source of tax arbitrage and takes away the main tax incentive to issue premium bonds.
Alternative explanations
Although tax arbitrage would be enough of a motivation to issue premium bonds, there are other plausible explanations for their issuance. Hilariously, these alternative explanations also involve some sort of gimmick.
Cleveland Fed economists Whitaker and Ergungor argue that premium bonds are issued as a workaround to self-imposed debt limits. Debt limit rules appear to be unaffected by the GASB 34 requirement of accrual accounting, and therefore a premium bond issued at 120 contributes only 100 towards the debt limit. So far this gimmick has only been used by local issuers like the school district mentioned at the top of this article, but in principle it could be used by the federal government as well: Matt Levine proposed issuing premium bonds as a workaround to the United States debt ceiling problem. This factor may explain why relatively many taxable municipal bonds are issued at a premium (10% in 2015) compared to other taxable bonds (less than 1%). However, this factor does not depend on the bonds’ tax status, and therefore it cannot explain why, in the municipal market, tax-exempt bonds are overwhelmingly more likely to be issued at a premium (85%).
Similarly, Andy Kalotay argued that, for callable bonds, a premium issue price creates illusory savings from exercising the refunding option. Many issuers have self-imposed restrictions to the effect that a bond can be called only if the refunding achieves a certain savings threshold. However, refundings can serve as yet another way around borrowing limits. Illusory savings from the refunding of premium bonds fit the legal definition of savings and help get around the restrictions.6 This factor, too, may enhance state and local governments’ incentive to issue premium bonds. However, by definition it only applies to callable bonds. In reality, noncallable bonds are issued at a premium more frequently than callable bonds (94% versus 64% in 2015).
These additional “creative accounting” motives for the issuance of premium bonds are important, but they are not mutually exclusive with the tax arbitrage motive I highlight in my paper. Rather, they are complementary. The tax code contains a loophole that subsidizes the issuance of premium bonds, and this loophole rewards lack of fiscal discipline at the state and local level.
Footnotes
- The U.S. Treasury avoids premium bonds on purpose. Treasury Auctions are regulated by 31 CFR Part 356, the Uniform Offering Circular. The coupon rate is set in increments of 1/8 of a percentage point to produce “the price closest to, but not above, par” (§356.20). Why not just issue at par, or as close as possible to par? In a private communication, a Treasury official gave the following explanation: bidders commit funds equal to the par amount (100) before the actual price is known (§356.17 and §356.25). If the price were allowed to be at premium, (e.g., 100.01), the Treasury would have to request a tiny amount from each of the many bidders. Instead, with a small discount, Treasury simply has to send a tiny amount to each bidder, which is a lot easier.
- This number should be taken as a rough estimate. As Tufte says, “The study of politics, like the study of economics, is usually a one-digit science at best.” [Tufte, Edward R. (1977). Political statistics for the United States: Observations on some major data sources. The American Political Science Review, 71(1), 305-314]. Later he softened his stance to allow for the occasional second digit. Humility aside, 1.7 billion is my best estimate, and I have done nothing at all to inflate it.
- Premium bonds are less than 1% of all taxable bonds. Typically the exceptions are reopenings of existing bonds, for which the coupon rate is already determined, and the yield is out of the issuer’s control. Unfortunately, exempting reopenings from the ban would open another can of worms, the details of which are left as an exercise for the enthusiastic reader.
- According to a FAQ published on the IRS website, “BABs may be issued at par plus a de minimis amount of premium. Section 1273 of the Code provides that a de minimis amount of premium is an amount that is not greater than 1/4 of 1 percent of the stated redemption price at maturity for the bond, multiplied by the number of complete years to the earlier of the maturity date for the bond or the first optional redemption date for the bond, if applicable. Generally, up to 2.5 percent of premium over the stated principal amount of the bond may be considered to be de minimis premium for bonds that mature in 10 or more years.”
- As Sherlock Holmes would say, if you eliminate all other factors, the one which remains must be the truth.
- It works this way: suppose an issuer sells a 20-year callable bond that can be called after 10 years. The issue price is 120. If the bond were not callable, after 10 years it would be worth roughly 110 because of premium amortization. But the issuer has the option to redeem the bond at 100 – a “saving” of 10. Of course, everyone (issuer and investors) saw this coming, and therefore investors had demanded a much higher return to begin with, increasing the issuer’s costs. This cost has already been paid, so getting even by exercising the redemption option feels like “savings.”
