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The OID were all listed as "OID " in the title of the bond, so they were original issue.
There are not many bonds listed today ( Saturday) so I can't check if there were any OID bonds on Vanguard and Schwab for short term, but I think not. Most of the OID bonds I saw Friday were at least ten year duration. Some are priced at $75 to $80
I need to learn a lot more about the tax consequences of Munis.
We need to be precise here. In considering "appreciation coming out of a credit event", ISTM your focus is on the change in market discount due to something other than accretion. Bond or bond fund, no difference, that's a cap gain (or loss) either way.
In muni funds at least, one will rarely have imputed interest, because muni funds are managed so as not to distribute taxable income:
[M]any mutual fund companies, which control around one third of investments in municipal bonds, deliberately avoid market discount transactions even though purchasing these bonds would be good deals for their investors. Many investors in municipal mutual funds place their money with these funds expecting to receive distributions entirely exempt from tax, or perhaps expecting to pay capital gains tax, which may be evidence of superior bond picking ability by the mutual fund manager.
Interest on bonds is conceptually straightfoward, though not simple. Even though the detailed calculations can be a bit of a nightmare.
When one buys a bond from an issuer, one is buying a fixed rate of interest for the life of the bond (until maturity or call). That interest may be paid periodically or when the bond is redeemed (bought at one price and redeemed at a higher price at maturity, like a CD) or a combination of both. Regardless of the form the income takes, it is all interest and for munis, generally all tax-free.
Consider a "vanilla" muni issued with a coupon paying market rate, so the bond is priced at par. If market rates go up, the price of the bond will drop. It drops so that the net return, coupon plus "appreciation" to maturity yields the market rate of interest.
Now, instead of that discount coming from the issuer, it's coming from the market. The buyer is still buying a bond with a fixed rate of interest (combination of coupon and "appreciation"), so all the income is treated as interest, not gain. But since that extra interest comes from the secondary market seller, not from the original municipality issuer, that extra interest is taxable.
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A few numbers may help here. For clarity, I'll work with simple interest and ignore the effects of compounding. Say the market rate on 5 year munis is 4%. A muni might be issued with a 2% coupon and a price of $90.
(2% coupon + 2% price increase/year = 4% yield, give or take.)
After a year, the price has gone up to $92 and the buyer has received 2% in coupon payments. A total of 4%. The adjusted basis of the bond is $92, accounting for the accretion at 2%/year. And the buyer declares 4% in tax-free interest. This goes on for another four years until maturity. The adjusted cost basis is then $100, there is no gain upon redemption, and the buyer has declared 4% tax-free interest each year.
Suppose after a year the rate on the bond increases to 5%. That could be because market rates generally have increased, or because the particular bond had a credit event such as a technical default. It doesn't matter.
The bond is now priced at $88, so that in the four remaining years it pays ($100 - $88) + 4 x 2% coupon = $12 + $8 = $20, or 5%/year.
If the owner sells now, there will be capital loss of $4: $88 sale price - $92 adjusted basis.
The buyer of that bond is getting a bond with $8 remaining OID (adjusted basis is $92) and $4 of market discount. The seller, not the municipality, is paying that extra $4 of income. So, to maturity $8 of accretion is tax-free, $4 is taxable.
Most of these effects are the same whether held by an individual or by a mutual fund, which simply passes through the taxes. (Though as noted before, it can't pass through a capital loss, though it can carry it forward.)
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Take the same example, except instead of the bond yield rising to 5% it falls to 3%. As before, this could be the result of general market rate declines or because the bond issuer is recovering from a credit event. It doesn't matter.
The bond is now priced at $96, so that in the remaining four years it pays ($100 - $96) + 4 x 2% coupon = $4 + $8 = $12, or 3%/year.
The adjusted cost basis after a year is still $92, but the buyer is paying $96. That $4 is called acquisition premium. The buyer is still paying below par; nevertheless, there's a market premium, not a market discount. This is why I was interested in seeing a specific CUSIP. One isn't necessarily buying at a market discount simply because a bond is priced below par.
In summary:
Market discount, which is relative to the adjusted cost basis, is treated as taxable interest, generally upon sale. (Owner has option to declare annually.)
OID discount is treated as tax-free interest, declared annually, and used to increase adjust cost basis (much as reinvested divs change the cost basis of your mutual fund).
Market premium (price in excess of adjusted cost basis) for munis must be amortized; it reduces the annual amount of tax free interest declared and also reduces the adjusted cost basis.
Sale of a bond may be above or below the adjusted cost basis, resulting in a capital gain or loss.
All the examples above use simple interest. The actual calculations are significantly more complex. I've also disregarded de minimis treatment of market discount.
Comments
The OID were all listed as "OID " in the title of the bond, so they were original issue.
There are not many bonds listed today ( Saturday) so I can't check if there were any OID bonds on Vanguard and Schwab for short term, but I think not. Most of the OID bonds I saw Friday were at least ten year duration. Some are priced at $75 to $80
I need to learn a lot more about the tax consequences of Munis.
In muni funds at least, one will rarely have imputed interest, because muni funds are managed so as not to distribute taxable income: Ang, Bhansali, and Xing, Taxes on Tax-Exempt Bonds, Sept 10, 2008.
https://www.ruf.rice.edu/~yxing/muni.pdf
I suspect that at best one may find a footnote in an annual report but nothing quantified, e.g. Note 1(h) to Financial Statements, Franklin Mutual Shares Annual Report and Shareholder Letter, Dec 31, 2021.
https://www.franklintempleton.com/forms-literature/download/474-A
N.B. This footnote includes premiums, so we're talking about more than OID. It also includes market discounts/premiums.
When one buys a bond from an issuer, one is buying a fixed rate of interest for the life of the bond (until maturity or call). That interest may be paid periodically or when the bond is redeemed (bought at one price and redeemed at a higher price at maturity, like a CD) or a combination of both. Regardless of the form the income takes, it is all interest and for munis, generally all tax-free.
Consider a "vanilla" muni issued with a coupon paying market rate, so the bond is priced at par. If market rates go up, the price of the bond will drop. It drops so that the net return, coupon plus "appreciation" to maturity yields the market rate of interest.
Now, instead of that discount coming from the issuer, it's coming from the market. The buyer is still buying a bond with a fixed rate of interest (combination of coupon and "appreciation"), so all the income is treated as interest, not gain. But since that extra interest comes from the secondary market seller, not from the original municipality issuer, that extra interest is taxable.
---
A few numbers may help here. For clarity, I'll work with simple interest and ignore the effects of compounding. Say the market rate on 5 year munis is 4%. A muni might be issued with a 2% coupon and a price of $90.
(2% coupon + 2% price increase/year = 4% yield, give or take.)
After a year, the price has gone up to $92 and the buyer has received 2% in coupon payments. A total of 4%. The adjusted basis of the bond is $92, accounting for the accretion at 2%/year. And the buyer declares 4% in tax-free interest. This goes on for another four years until maturity. The adjusted cost basis is then $100, there is no gain upon redemption, and the buyer has declared 4% tax-free interest each year.
Suppose after a year the rate on the bond increases to 5%. That could be because market rates generally have increased, or because the particular bond had a credit event such as a technical default. It doesn't matter.
The bond is now priced at $88, so that in the four remaining years it pays
($100 - $88) + 4 x 2% coupon = $12 + $8 = $20, or 5%/year.
If the owner sells now, there will be capital loss of $4: $88 sale price - $92 adjusted basis.
The buyer of that bond is getting a bond with $8 remaining OID (adjusted basis is $92) and $4 of market discount. The seller, not the municipality, is paying that extra $4 of income. So, to maturity $8 of accretion is tax-free, $4 is taxable.
Most of these effects are the same whether held by an individual or by a mutual fund, which simply passes through the taxes. (Though as noted before, it can't pass through a capital loss, though it can carry it forward.)
---
Take the same example, except instead of the bond yield rising to 5% it falls to 3%. As before, this could be the result of general market rate declines or because the bond issuer is recovering from a credit event. It doesn't matter.
The bond is now priced at $96, so that in the remaining four years it pays
($100 - $96) + 4 x 2% coupon = $4 + $8 = $12, or 3%/year.
The adjusted cost basis after a year is still $92, but the buyer is paying $96. That $4 is called acquisition premium. The buyer is still paying below par; nevertheless, there's a market premium, not a market discount. This is why I was interested in seeing a specific CUSIP. One isn't necessarily buying at a market discount simply because a bond is priced below par.
In summary:
- Market discount, which is relative to the adjusted cost basis, is treated as taxable interest, generally upon sale. (Owner has option to declare annually.)
- OID discount is treated as tax-free interest, declared annually, and used to increase adjust cost basis (much as reinvested divs change the cost basis of your mutual fund).
- Market premium (price in excess of adjusted cost basis) for munis must be amortized; it reduces the annual amount of tax free interest declared and also reduces the adjusted cost basis.
- Sale of a bond may be above or below the adjusted cost basis, resulting in a capital gain or loss.
All the examples above use simple interest. The actual calculations are significantly more complex. I've also disregarded de minimis treatment of market discount.