Pub. 8 2019 Issue 3

23 F A L L | 2019 Jim Reber is president and CEO of ICBA Securities and can be reached at (800) 422-6442 or jreber@icbasecurities.com . Why do tax-free bonds have lower price volatility than taxable bonds? Another popular question. The best way to illustrate this is to take a hypothetical taxable bond, like a 10-year Treasury note, and compare it to a 10-year tax-free bond. At the moment, the 10-year Treasury yields (conveniently) 1.50%, and 10-year high-quality munis yield about 1.65% (for a tax-equivalent yield of 2.05%). If rates rise 100 basis points (1.0%), the Treasury will then yield 2.50% and its price will decline 8.7%. The muni will only have to drop by 6.9% for its tax-equivalent yield to get to the 3.05% that the market will likely require. It’s worth noting that the two bonds’ volatilities have become more alike since tax reform at the end of 2017. Stated another way, muni price vola- tilities have increased as tax rates have fallen. Why is the duration of a bond shorter than its average life? The most commonly used measurement for price volatility of a fixed-rate security is duration. It is the weighted average period of time to receive all the principal and interest on a bond. Average life, on the other hand, is a tool used in many cases to forecast cash flows on mortgage securities and is the weighted-average time to receive principal only. Since most MBS are back-loaded with principal on their paydown sched- ules, average lives are almost always longer than duration for a given bond. Duration is useful for estimating how much a bond’s value will change given a change to market rates. A duration of F E A T U R E 3.0 means that the price will decline about 3%, given a 1% increase in the market yield. Concepts like effective dura- tion and convexity also factor into this discussion, but that’s another story for another day. Why are bankers more inclined to sell at gains than losses? I’m no shrink, but there is an element to behavior that psychologists refer to as “compartmentalization.” It seems to me that taking a loss is seen by the seller as admission of a bad purchase. In fact, the overwhelming majority of losses realized are market-driven, and I think we agree that bankers aren’t market-timers. So, by being more inclined to take gains, portfolio managers can neatly stack their aggregate sales in the “win” column. There are just two problems with this practice: selling the winners means your portfolio yield is probably going down, and you’ve triggered immediate tax liability. I would sug- gest, especially in a robust earning year like the present, that a bank work with its tax accountant and brokers to devise an income-deferral strategy. Higher yields mean more future in- come. And that falls into the “long-term vision” compartment. Another popular question. The best way to illustrate this is to take a hypothetical taxable bond, like a 10-year Treasury note, and compare it to a 10- year tax-free bond. At the moment, the 10- year Treasury yields (conveniently) 1.50%, and 10-year high-quality munis yield about 1.65% (for a tax-equivalent yield of 2.05%).