The time to swap municipal bonds may be right now
As if people didn't have enough to think about during the holiday season, now investors holding municipal bonds are being asked to consider some tax-saving swaps.
People can sell tax-free municipal bonds for a loss up until the last trading day of the year, says Steven J. Hueglin, executive vice-president of Gabriele, Hueglin & Cashman Inc., a New York bond-trading firm. Despite the rise in bond prices in recent months, there are plenty of losing bonds parked in investors' portfolios.
Municipal bonds are probably the easiest security to swap. Their price is almost directly tied to interest rates, and they are mostly of high quality.
Bond swapping involves selling bonds that have decreased in value and using the loss to offset capital gains or other income. The proceeds are then reinvested in similar bonds of equal or superior quality.
For example, Mr. Hueglin notes, an investor may have bought $25,000 of Georgia Municipal Electric Authority A1-rated bonds at par (100 cents on the dollar) in 1976. The bonds have a 6.125 interest rate and are due Jan. 1, 2012. Today, they might be sold for 56 cents on the dollar, a loss of $11,000. This loss, applied to long-term gains from the sale of stock or real estate, could save the investor over $3,000 in federal and state income taxes.
The investor could then buy $25,000 Nebraska Public Power District A1-rated 6 .125 percent bonds due Jan. 1, 2013. He would pay 57.375 cents on the dollar for them. The 1.375 point difference represents the trading costs, and the investor's income is unchanged. The key here, however, is that the investor takes a loss on the $11,000 now and pays taxes on the same amount in 2013. ''You realize the loss now and postpone the gain for 30 years,'' Mr. Hueglin says.
The best bonds for swapping are at least three years old, he adds. ''Bonds purchased up through 1979 and in the summer months of 1980 will show a loss,'' he says. This is because the October 1979 decision by the Federal Reserve Board to pay more attention to the growth of the money supply, rather than interest rates, in determining monetary policy resulted in both greater volatility and higher interest rates. The value of bonds purchased before then declined.
Usually, he adds, December is not a good time to be swapping bonds, because the market is flooded with bonds other people are trying to swap and the market is less competitive. So an early start, like November, is normally a better course.
But this year, bond prices are coming back up, and people do not seem as eager to swap old bonds. There are some good reasons for making swaps now anyway , Mr. Hueglin says.
First, people can use swaps to switch from shorter-term bonds into longer-term securities.
Second, this is a good way to move up to quality. If, as Mr. Hueglin and others trying to forecast the economy say, the US is in for several more months of economic doldrums before a real recovery begins, higher-quality bonds are one way an investor can buy some protection.
Third, if interest rates keep dropping, an investor with callable bonds may be in danger of having them unexpectedly called. At that time, there will not be higher-yielding, top-quality bonds available. So the investor would have to switch to lower-earning bonds.
''And tax exempts are going to keep dropping,'' Mr. Hueglin says.
One thing an investor should be careful about in swapping bonds is avoiding a ''wash sale.'' This situation is created when substantially identical securities are sold and purchased in order to take a tax loss. This is prohibited by the Internal Revenue Service. To avoid a wash sale, the issuer, interest rate, or maturity should be sufficiently different to satisfy the IRS. As a general rule, for instance, there should be at least a 10 percent difference in yields. Your broker or bond dealer can help you find new bonds that qualify.
A broker can also help you find new bonds to buy in the swap, but it is probably a good idea to check with a few brokers to be sure of getting the best deal, both on the bonds you are selling and on the new ones.
There is a trading cost in swapping. You should not enter into it unless the gain more than offsets these costs.
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