Par Munis -- Sub-Par Performance

It is well recognized that institutional municipal portfolio managers prefer premium bonds to those selling near par. We show that such aversion to par bonds is justified, because they are expected to underperform comparable premium or discount bonds in the near term. The extent of the underperformance depends on the shape of the yield curve, and it is positively correlated with the level of expected interest rate volatility.

The underperformance is due to tax considerations. When a municipal bond is purchased below par, the resulting gain is taxed at maturity, and the price is depressed by the present value of this tax. Due to this tax effect, the interest rate sensitivity of discount munis is amplified. Munis selling near par are also negatively convex; the potential decline due to higher interest rates exceeds the increase due to commensurately lower rates. The underperformance of near-par munis relative to those selling at a high premium or at a deep discount is due to the resulting combination of extended duration and negative convexity.

The changing value of tax liabilities creates a unique challenge in determining interest rate sensitivity and expected return, which conventional analytics fail to recognize. The tax-neutral analytics used in this paper incorporate the value of future tax costs, and provide an accurate method for predicting municipal bond price changes and investment returns.