Various studies have shown that Banks with higher performing investment portfolios often have a higher allocation to municipals. The purpose of article is to illustrate how banks can profitably and efficiently invest in specific types of tax-exempt municipals, a sector of the broad bond market where banks continue to find strong credit quality and higher returns. As important, many banks have taken advantage of the investment subsidiary structure to eliminate its tax liability relating to interest expense disallowance (“TEFRA”), especially as cost of funds is starting to increase in today’s environment.
Banks invest in municipal bonds primarily to generate tax-advantaged income. With the security portfolio often being the second largest earning asset on a bank’s balance sheet, it is important to take advantage of the earnings your investments can produce. A portfolio with an allocation to municipal bonds can help protect or expand net interest margin (NIM), which had come under pressure at many institutions in any rate environment. Also, banks that rely on other sources of income, such as mortgage banking, are seeing its overall profitability decline with mortgage rates increasing by nearly 300 basis points from 2021 lows.
Bank Qualified and General Market Municipal Bonds
Within the tax-exempt municipal bond market, there are two broad categories of municipal bonds, Bank Qualified (BQ) and General Market (GM). While both types are bank permissible investments, BQ is the more common type for banks to own. (GM municipals are sometimes referred to as “non-bank qualified”, which is a misleading term, because they are bank permissible investments). In fact, there are two main differences between BQ and GM municipals: supply and tax treatment.
Supply and Demand of BQ and GM Municipals and Impact on Returns
For a bond issue to receive BQ status, the issuer is typically limited to issuing $10 million per calendar year. This means that BQ municipals can be cumbersome to accumulate and manage due to their low supply, small lot sizes, and large CUSIP count. For a bond issue to receive GM classification, the issuer would need to issue more than $10 million per calendar year. It is common for GM municipals to comprise over 90% of the yearly tax-free issuance in the municipal bond market. As a result, the larger supply of GM municipal bonds can offer several advantages over BQ.
- Better relative value (i.e., higher yields) for comparable duration and credit quality.
- Larger deal and lot sizes can mean better liquidity.
- Larger municipalities often have more financial transparency to perform purchase documentation and ongoing credit due diligence. This has been an area of growing importance among regulators.
Why would GM municipals have better relative value and higher yields than BQ municipals, all else equal? The answer is the much lower supply of BQ securities (<10% of total tax-free municipal issuance) coupled with higher demand from banks, which causes prices for BQ securities to be higher (lower yields) relative to GM.
Tax Treatment of Municipals – TEFRA Penalty Explained
Regarding their tax treatment, BQ and GM municipals are both subject to interest expense disallowance, a.k.a., the TEFRA penalty. Originating in 1982 from the Tax Equity and Fiscal Responsibility Act, the most relevant part of TEFRA relates to the ability to deduct interest expense for banks with tax-exempt securities (i.e., municipal bonds). The tax code does not allow banks to deduct interest expense on liabilities that were used to buy tax-free securities. This was perceived as “double dipping” and is known as the 100% Disallowance Rule. However, an exemption exists for BQ securities. For BQ securities, 80% of the interest expense is deductible, and only 20% is “disallowed”. For GM municipals, 100% is disallowed, meaning that the TEFRA penalty is five times as high for GM municipals compared to BQ municipals.
The TEFRA penalty depends on three factors: a bank’s interest expense (cost of funds), the tax rate, and the disallowance (20% for BQ and 100% for GM). As an example of calculating an estimated TEFRA penalty, consider a bank with a cost of funds of 100 bps and a tax rate of 21%.
Estimated TEFRA penalty for a BQ security is: (100 bps) x (21%) x (20%) = 4.2 bps.
Estimated TEFRA penalty for a GM security is: (100 bps) x (21%) x (100%) = 21 bps.
With market rates staying low over the past several years resulting on lower cost of funds, banks have been taking advantage of higher yields with outright purchases of GM municipals. With the cost of funds rising for many banks, there is a real concern that TEFRA penalty can increase substantially. Luckily, there is a strategy component that enables banks to continue owning tax-free municipals without being subject to interest expense disallowance.
Tax Efficient Strategy for Managing Tax-Free Municipals
There are certain tax structures available to banks to achieve the most efficient tax ownership of general market municipals, effectively eliminating TEFRA disallowance. When organized and managed properly, an investment subsidiary structure can eliminate TEFRA penalty while preserving control over and liquidity of these investments. This process generally works most efficiently when established and managed with the help of a qualified independent investment advisor.
With funding cost rising for financial institutions, the investment subsidiary structure is a great way to optimize your tax-exempt holdings by also capturing the wide spread of the GM sector over the rich BQ market and efficiently owning them to maximize returns and risk oversight with sound and defendable business purpose. An important aspect of this strategy is the increased profitability does not come from taking undue interest rate or credit risk. Rather, the economic benefit results from the relative value of high-quality GM municipals over other bank-permissible investment sectors and tax savings.
Tax-exempt municipals will continue to play an important role in the effort to expand or protect net interest margin in a challenging rate environment and can help enhance the earnings contribution from your institution’s investment portfolio. Partnering with an effective investment advisor can help ensure best execution on municipal purchases and facilitate new issue product and pricing through senior deal underwriters, helping expand the investable universe of high-quality municipal bonds beyond what your broker may have access to on any given day. With enhanced execution and a properly structured investment subsidiary, you can succeed in optimizing the earnings benefit from your tax-free municipal portfolio.
Taylor Advisors has been serving as a registered independent advisor for over 20 years and has worked with dozens of clients to establish and properly manage investment subsidiaries, while serving in a fiduciary capacity. If you would like to learn more about these strategies or to determine if your institution would be a good candidate, click here.
Taylor Advisors, Inc. is a balance sheet consulting firm and a registered investment advisor based in Louisville, Kentucky. We are not a brokerage firm, but a team of asset liability analysts and balance sheet consultants to community-based financial institutions. Our service is quite simple. We help banks improve or maintain profitability while managing various risks – what we call Balance Sheet Management (BSM). BSM consulting entails providing advice, strategies, monitoring, and most importantly, education in many areas: investments, asset/liability, liquidity/funding, and risk management.
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