A Smarter Way to Buy a Jet Card?
By: Andy Parker; Twenty-First Securities
Historically, when an investor has needed to fund a large purchase such as a jet card, the traditional technique has been to raise cash by selling securities. These days however, the issue may not be so simple. Given the increase in the level of equity markets as well as the decline in interest rates, many portfolios – both stock and bond – likely have large unrealized capital gains. For any temporary cash need, selling stocks or bonds and paying capital gains tax may be an inefficient strategy. This is particularly true with municipal bonds with high coupon levels. Selling high-coupon municipals essentially takes a long-term tax exempt income stream and converts it to cash and a capital gains tax – not a tax-efficient solution.Borrowing the funds against a securities portfolio may in fact be a more cost effective strategy. In general, bonds are a useful asset to post as loan collateral. Unlike stocks which can have price volatility and the potential for “margin calls”, bond prices are generally more stable. That said, municipal bonds posted as loan collateral create a specific problem. The IRS, through IRC §265, states that interest expense incurred for the purchase or carrying of tax-exempt bonds will generally be disallowed as a federal income tax deduction. Due to this rule, the general conclusion is that municipal bonds cannot be posted as loan collateral.
In fact, at Twenty-First Securities, we have identified a capital markets transaction that could satisfy the investor goal of raising cash while still preserving some “tax benefit” from the carrying costs.
The transaction utilizes exchange traded options; it allows an investor to borrow money at a fixed rate for a specified period of time that is locked in at the inception of the trade. This “box spread” consists of a combined “synthetic long” position and a “synthetic short” position.
When an investor combines a synthetic long position and synthetic short position in the same stock or index, the investor is no longer exposed to changes in the price of the underlying stock or index and has effectively created a “riskless position”. Exchange traded options offer daily pricing and liquidity but if the trade is unwrapped early, the results are no longer locked-in.
When the trade is put on, the differences in the strike prices used will create a credit in the clients account. This credit can be taken from the account as long as it is properly collateralized by the muni portfolio. The investor will receive a net premium or cash inflow at the inception of the trade and will know exactly what amount is expected at the expiration of the option contracts; the difference between the two amounts makes up the cost the investor will incur. It is very much like borrowing at a fixed rate for a fixed term through a zero coupon loan. Example: An investor ”borrows” through a one year “Box Spread”. The synthetic long and synthetic short positions produce a net premium of $99 on the day after trade date. At expiration, the investor would have to close the position and no matter where the index is will have to pay $100. The $1 of loss is treated as a capital loss for tax purposes.
Although the “box spread” is collateralized by the municipal bonds there is no interest expense incurred on the transaction for federal income tax purposes. Capital losses incurred on a transaction collateralized by municipal bonds should not be disallowed under IRC section 265. However, the investor must have capital gains from other transactions in order to utilize the capital losses incurred on the option transactions.
The “Box Spread” offers customizable maturities and currently the implied borrowing costs are lower than fixed rate loans that are being offered in the marketplace. This strategy provides a unique opportunity for astute investors seeking to raise cash but not sell their munis.
Twenty-First Securities ♦ 780 Third Avenue, 24th Floor ♦ New York, NY 10017 ♦ 212.418.6000 ♦www.twenty-first.com