With the recent increase in interest rates, de minimis risk has again started to loom amid the jungle of potential pitfalls for municipal bond investors.

When rising rates drive prices lower, more bonds become subject to a tax penalty, as appreciation from the discounted price can be treated as a capital gain or even regular income.

The recent downturn has pushed an estimated 6% of the muni market into de minimis territory as of Aug. 6, according to a Morgan Stanley research report. Were muni yields to hurdle another 60 basis points, about 20% of the market would be subject to the penalty.

The risk peaks for bonds with maturities of between seven and 15 years, and persists out to 33 years, analysts say. If enough bonds trade below de minimis levels, the possibility for volatility in yields increases dramatically.

Still, muni pros liken the current risk surrounding de minimis to a price adjustment that can occur whenever the overall market weakens, and see no reason to fear a free-fall, said Matt Fabian, a managing director at Municipal Market Advisors.

"It's like we hit an air pocket and the market drops; it's just a step down," he said. "But there is still demand for [munis]. People are always optimistic about what their future tax rate is going to be."

And muni investors have options for managing the risk. Those carrying higher-credit paper can hold to maturity and weather the storm. They can replace maturing debt with higher-coupon bonds. Or they can shorten their maturity to try to counteract the volatility hitting their portfolios.

For new buyers, more bonds in de minimis could also mean more opportunities to capture muni income at steep discounts.

Muni yields have been on the rise since May 1, fueling the de minimis concerns. The 10-year triple-A yield has jumped 113 basis points through Tuesday to 2.79%, Municipal Market Data numbers show. The two-year has climbed 14 basis points over the span to 0.43%; the 30-year has rocketed 154 basis points through Tuesday's close to 4.33%.

Coupon interest income on munis is typically exempt from federal taxes, but the price appreciation on a bond purchased at a discount in the secondary market may be taxable.

Bonds can trade at an amount below par equal to one-fourth of 1% of the principal amount of the bond multiplied by the number of full years until the bond's maturity. To remain above de minimis, a bondholder can't get more than a quarter point of appreciation per year of holding the bond.

As prices fall during a selloff and bonds close in on — or actually fall into — de minimis, the yields must be adjusted to reflect the tax rates that have to be applied to that holding, said Tom Dalpiaz, senior vice president and portfolio manager at Advisors Asset Management.

If a bond falls to de minimis, the rule is that appreciation is taxed at a capital gains rate; and if it falls at a discount that pushes through de minimis, Dalpiaz added, it's then taxed as ordinary income.

"These are drags on the yield that you have to account for," he said. "So as bonds get close to or fall into de minimis, their yields have to be adjusted for after-tax implications, and that just means more volatility."

Fund managers know the risks, and typically have more sophisticated means for assessing them. Most portfolio managers will rotate out of paper that will become potential de minimis bonds and rotate into higher-coupon-structured bonds that would be better protected from de minimis, said Douglas Gaylor, a portfolio manager at Principal Global Investors.

"Seasoned portfolio managers need to be aware of that and position bonds appropriately," he said. "And the way they do that is by selling their bonds after they become discount bonds, or when they get close to a discounted-type bond, they usually sell it to retail and then buy higher-coupon bonds where interest rates would have to move up quite a bit more before they become subject to de minimis."

In general, buyers must be more careful when making a purchase when prices approach de minimis, Fabian added.

"You have to pay attention to the exposure, because your prices are getting low," he said. "It's not as simple as 25% per year, because it works through the original issue's discount."

Advisors Asset Management tends to buy paper in the intermediate part of the yield curve, Dalpiaz said, and has always focused on bonds with coupons of at least 4%. Those investors who buy bonds with low coupons and that are purchased near par now must address de minimis concerns, he added, unlike those who bought bonds with coupons above 4%, depending on the maturity.

"That's less of a worry for them," Dalpiaz said.

Bondholders worried about de minimis can take some action to minimize their risk. They can "hold tight and know that if you're patient and the entity is credit-worthy, you'll get par when it matures," Dalpiaz said. "That's a possibility."

Holders can also shorten their maturity to try and neutralize the volatility, he added. But there could well be some difficulty associated with that.

An investor who bought par bonds or paper close to par when rates were low, and is facing de minimis, must reflect the additional tax implications when trying to sell them.

"The bids on these may not be as good as you would've thought," Dalpiaz said. "So I don't know how flexible swapping these kinds of items will be in this environment."

Bond buyers should look for credits that are at least A-rated, which offer a chance to get high-quality income in credits with intermediate and long maturities, Morgan Stanley wrote. Buyers can also evaluate cheapness.

"If the tax-adjusted value of a bond in de minimis is lower than a comparable bond without a tax liability on market discount," Morgan Stanley wrote, "an income opportunity may exist."

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