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Although perhaps all to easy to dispense with in the excitement of invest-
ing, paying taxes is, regrettably, a fact of life”unless one is investing on
behalf of not-for-profit entities. Taxes can make a very large impact on an
investor™s realized total returns. The goal of this chapter is to highlight how
consideration of taxes can have a very important impact on an investor™s
decision making.
In the United States, as in most other developed financial markets, equi-
ties and bonds can be subject to a variety of different tax structures. There
is the capital gains tax, which is differentiated into a short-term rate (for
holding periods of less than one year) and a long-term rate (for holding peri-
ods of more than one year). As an incentive to investors to hold on to their

241

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242 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT



investments and minimize short-term profit-taking strategies, the long-term
capital gains (gain on the amount of principal invested) tax rate is less than
the short-term capital gains tax rate. Then there are some cash flows, such
as coupons, that are subject to tax not at a capital gains rate but at a rate
consistent with an investor™s ordinary income (non-investment-related) tax
bracket. Further, some fixed income instruments are taxed only at a city,
state, or federal level, or at some combination of these. For example,
Treasury bonds are exempt from federal tax (but not state and local tax1),
while selected bonds of federal agencies are subject to federal tax but not
state and local tax. And finally, there are even types of investment vehicles
that benefit from certain tax advantages. Examples of these would include
401(k)s (retirement accounts), 529s (college savings accounts), and individ-
ual retirement accounts (IRAs). Aside from being subject to differential tax
treatment, these products also may impose severe penalties if investors do
not follow prescribed rules pertaining to their usage.
Although it seems obvious to say that the way a security is taxed can
greatly affect its contribution to a portfolio™s total return, tax effects are often
overlooked. For example, in the case of mutual funds, it is not the fund man-
ager who is taxed, but the individuals who invest in the fund. Accordingly,
each year fund investors receive a statement from their fund company that
reports the tax effect of the fund™s various investments; the investor is
required to report any tax liability to appropriate tax authorities. Since tax
liabilities are passed through to investors and are not directly borne by fund
managers, investors will want to be aware of a fund™s tax history prior to
investing in it. A particular fund™s returns might look impressive on a
before-tax basis but rather disappointing on an after-tax basis, especially if
the fund manager is aggressively engaged in tax-disadvantaged strategies in
the pursuit of superior returns. As the result of a recent ruling by the
Securities and Exchange Commission (SEC), today funds are required to
report both before- and after-tax returns, and there™s sound reasoning for
this requirement.
Specific examples of how taxes might transform a bond from one that
looks desirable on the basis of its yield to be relatively unattractive on the
basis of its after-tax total return follow. In particular, let us focus on the bonds
of various federal agencies. Table 6.1 presents an overview of how various
federal agency bonds are taxed at the federal, state, and local levels.
As shown in Table 6.1, there are discrepancies among the agencies in
the terms of their tax treatment. For example, while Fannie Mae and
Freddie Mac are not exempt at the state and local levels, the Federal Home
Loan Bank and Tennessee Valley Authority are.


1
Not all states and localities impose taxes.




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243
Market Environment



TABLE 6.1 Taxable Status of U.S. Federal Agency Bonds
Tax Exempt Tax Exempt
Issuer Federal Level State & Local Level

Federal Home Loan Banks No Yes
Federal Farm Credit Bank No Yes
Federal Home Loan Mortgage
Corporation (Freddie Mac) No No
Federal National Mortgage Association
(Fannie Mae) No No
Tennessee Valley Authority No Yes
Agency for International Development No No
Financing Corporation No Yes
International Bank for Reconstruction
and Development No No
Resolution Funding Corporation No Yes
Private Export Funding Corporation No No
Tax laws are subject to frequent changes, and investors ought to consult with their
tax adviser prior to investing in any of these securities.


Table 6.2 provides tax-adjusted total return scenarios whereby an
investor (for our purposes here, an investor taxed at the applicable corpo-
rate tax rates) can compare one agency to another or to another fixed income
sector. The assumptions are provided so that readers can see exactly how
numbers were generated.
As shown in Table 6.2, at first pass, the nominal spread differences of
the agencies to the single-A rated corporate security appear rather mean-
ingful. Yield differences between the agencies and the cheaper corporate secu-
rity range from 38 basis points (bps) with the five-year maturities, to 45 bps
with the 10-year maturities, and to 59 bps with the 20-year maturities. Yet
when we calculate tax-adjusted total returns, the spreads that are there when
stated as nominal yield differences dissipate when expressed as total return.
Indeed, they invert. The total return advantage for state and local exempt
agencies (Federal Home Loan Bank and Tennessee Valley Authority [TVA]
in these instances) relative to the single-A corporate security is 12 bps for
five-year maturities and 2 bps for 20-year maturities. Since the analysis
assumes constant spreads over the one-year investment horizon, any outlook
on the relative performance of these securities is certainly of relevance.
The choice of an 8 percent benchmark for state and local tax rates
(combined) is lower than the national average. If we were to single out New
York, for example, the state and New York City rates would combine to
just over 10%. Massachusetts at the state level alone is at a rate of more
than 10 percent. Using a combined state and local tax assumption of 9 per-



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244 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT



TABLE 6.2 Tax-Adjusted Total Returns of Agency vs. Corporate Securities,
One Year Horizon

5-Year Nominal Nominal After-Tax Return (%)
Maturities Spread (bps) Yield (%) (1) (2) (3)

Fannie Mae 2 5.66 4.47 3.91 3.34
FHLB 21 5.66 4.81 4.25 3.68
Single-A corporate bond 59 6.04 4.77 4.17 3.56
10-year Maturities
Fannie Mae 30.5 5.89 4.65 4.06 3.47
FHLB 30.5 5.89 5.00 4.41 3.83
Single-A corporate bond 76 6.34 5.01 4.37 3.74
20-year Maturities
Fannie Mae 25 6.17 4.87 4.26 3.64
TVA 25 6.17 5.24 4.63 4.01
Single-A corporate bond 84 6.76 5.34 4.66 3.99
(1) Represents after-tax rates of return; rates after federal tax rate of 15% and a
state and local tax rate of 8%.
(2) Represents a federal tax rate of 25% and a state and local rate of 8%.
(3) Represents a federal tax rate of 35% and a state and local rate of 8%.
Assumptions: It is assumed that securities are purchased and sold at par and are
held over a one-year horizon. This par assumption allows us to ignore consideration
of capital gains and losses, though when we do incorporate these scenarios, our
results are consistent with the overall results shown. We also assume that at the time
of the security™s purchase, the present value of future tax payments are set aside,
quarterly for federal corporate tax and a one-time filing for state and local corpora-
tion tax. All cash flows are discounted at the respective security™s yield-to-maturity.
Finally, our choice of 8% as a benchmark rate for state and local tax is less than the
average of the highest and lowest rates across the country. One motivation for using
a lower-than-average rate is to attempt to incorporate at least some consideration of
how federal tax payments are deductible when filing state and local returns.


cent, the total return advantage of an agency to a single-A corporate secu-
rity widens to 30 bps at the highest federal tax rate for five-year maturi-
ties, to 28 bps for 10-year maturities, and up to 22 bps for 20-year
maturities. Clearly, for buy-and-hold-oriented investors, these total return
differentials may appreciably enhance overall performance over the life of
a security.
While we have touched on many issues here related to tax considera-
tions, there are others. For example, there is the matter of relative perfor-
mance when capital gains enter the picture. In all likelihood, the price of a
given security at year-end will not be what it was at the time of initial trade.
However, under some basic what-if scenarios, the relative performance sto-
ries above generally hold with both capital gain and loss scenarios (assum-



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ing duration-neutral positions for like changes in yield levels, constant
spreads).
In addition to applying a tax analysis to notes and bonds, we also can
apply it to shorter-dated money market instruments like discount notes.
Applying a methodology similar to the one used in the note and bond analy-
sis, we examined three- and six-month discount notes against like-maturity
corporate securities.
As shown in Table 6.3, yield differences between discount notes and a
short-dated corporate security range from 26 bps with three-month instru-
ments to 38 bps with six-month instruments. Since the state and local tax
exemptions that apply to agency bonds also apply to discount notes, on a
tax-adjusted basis we would expect initial yield advantages to dissipate into
total return advantages favoring different issues. In the analysis, the total
return advantage for the state and local exempt agencies (Federal Home


TABLE 6.3 Tax-Adjusted Total Returns for Agencies versus
Corporates, Annualized

After-Tax Return (%)
Spread (bps) Yield (%) (1) (2) (3)

3-month instruments
FHLMC discount note 48 5.51 4.31 3.80 3.30
FHLB discount note 48 5.51 4.68 4.24 3.74
Corporate Baa1-rated Libor 10bps 5.77 4.51 3.98 3.45
6-month instruments
FHLMC discount note 34 5.53 4.32 3.81 3.80
FHLB discount note 32 5.51 4.68 4.13 3.58
Corporate Baa-rated Libor 20bps 5.89 4.60 4.06 3.52
(1) Represents after-tax rates of return based on a federal tax of 15% and a state
and local tax rate of 8%.
(2) Represents federal tax rate of 25% and a state and local tax rate of 8%.
(3) Represents federal tax rate of 35% and a state and local tax rate of 8%.
Assumptions: It is assumed that securities are purchased at a discount and are held
to maturity. This par assumption allows us to ignore consideration of capital gains
and losses, though when we do incorporate these scenarios, our results are consis-
tent with the overall results presented. We also assume that at the time of a secu-
rity™s purchase, the present value of future tax payments are set aside, quarterly
for federal corporate tax and a one-time filing for a state and local corporation
tax. All cash flows are discounted at the respective security™s yield-to-maturity.
Finally, our choice of 8% as a benchmark rate for state and local tax is near the
average national rate. Note, however, that tax rates vary considerably from state
to state, and consultation with a tax adviser is recommended.




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246 FINANCIAL ENGINEERING, RISK MANAGEMENT, AND MARKET ENVIRONMENT



Loan Bank and Farm credit, for instance) relative to the corporate security
is 26 bps for three-month instruments and 7 bps for six-month instruments.
This assumes a combined state and local tax rate of 8 percent and a federal
corporate tax rate of 25 percent. To reiterate, because the analysis assumes
constant spreads over the investment horizon, any outlook on the relative
performance of these securities, though relevant, is not fully considered here
for purposes of keeping the analysis cleaner. And again, investors should con-
sult with appropriate tax advisers when evaluating these opportunities.
As a final statement about tax-related considerations, note that tax treat-
ments may well influence the type of structure that one agency might prefer
offering over another. Consider Federal Home Loan Bank (FHLB) (exempt
from state and local taxes) and Fannie Mae (not exempt from state and local
taxes) debt issuance. In contrast to Fannie Mae, the FHLB is predisposed to
offering callable product with lockouts of under one year. Although Fannie
Mae and the FHLB have different funding objectives that mirror their dif-
ferent mandates, it is nonetheless striking that the overwhelming bias of
Fannie Mae is to bring its callables with lockouts longer than one year (at
62 percent), while the FHLB brought the majority (76 percent) of its callables
with lockouts of 12 months and under. This phenomenon is consistent with
the FHLB wanting to appeal to yield-oriented investors, such as banks, that
are able to take advantage of the preferential tax opportunity provided by
the FHLB™s shorter lockouts and higher yield spreads.2
This type of tax adjustment total return methodology certainly appeals
to individual investors as well as investors at corporations not generally sub-
ject to unique industry-specific categories of tax law. Investment divisions
in corporate goods sectors (e.g., manufacturing) would find a stronger moti-
vation for this approach than, say, corporate services sectors (e.g., insurance).
All else being equal, if it were possible for tax policy to be applied within
the marketplace such that no heterogeneous distortions could emerge, then
it is plausible that the market would continue along in much the way that
it would have done in the absence of any kind of tax policy. The reality, how-
ever, is that the temptation to use tax as a policy variable (namely a non-
homogenous application of taxes) is a powerful one, and as such it can give
rise to market opportunities.
As with regulations, tax policy can be used to deter or promote certain
types of market behavior. It also can be the case that the tax is put into place

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