Specific investment opportunities come and go with the ever-changing economic and interest rate climates. That’s not the case with taxable and tax-exempt municipal securities. It’s very hard to see how municipals would not play a central role in a bank’s investment portfolio, no matter what the prevailing climate.
Taxable Municipal Securities
Taxable municipal securities have a place in almost every community bank. If your bank does not have enough taxable income to purchase tax-exempt securities, it can buy taxable municipals. Taxable municipal securities can be an attractive alternative to corporate bonds or mortgage-backed securities.
Taxable municipals do not have the prepayment characteristics of mortgage-backed securities and can have long-call protection. They are similar to corporate bonds in their structure but can be obtained with insurance, minimizing credit risk with the AAA rating.
Tax-Exempt Municipals Can Help Lower Taxes
Tax-exempt municipals can be a very solid investment, plus they can be used to lower your bank’s tax rate. Of course, bank executives and directors make sure that the tactics to lower taxes fit the bank’s strategic goals.
Before a strategic tax plan can be created, executives and directors must make sure that all the appropriate facts have been gathered. They need to get to understand the bank’s tax position and review the other tax-exempt assets on the balance sheets, such as bank-owned life insurance (BOLI).
Not All Tax Rates Are Created Equal
You need to look at three different tax rates at your community bank so you can create the most advantageous tax policy for your bank. The three rates are:
- Accounting tax rate
- Effective tax rate
- Marginal tax rate
Accounting Tax Rate
The accounting tax rate is the bank’s income tax provision, including both current and deferred provisions, divided by the income before taxes. The accounting tax rate is used when determining net income or earnings per share (EPS) calculations.
Accounting Tax Rate =
(Current Tax Provision + Deferred Tax Provision) ÷ Income before Taxes
Effective Tax Rate
The effective tax rate is the current tax provision divided by income before taxes.
Effective Tax Rate = Current Tax Provision ÷ Income before Taxes
For most community banks, the effective tax rate will be different than the statutory rates in the tax codes. In some cases, the effective rate can be more than the accounting rate. That can occur because of the effect of loan loss provisions and expiring deferred tax credits that are disallowed on the tax return.
Don’t forget that your bank also may be subject to state taxes. These, too, should be factored into the effective tax rate.
Most Community Banks Pay Too Much in Taxes
If you are like most bankers, you are paying too much in taxes. Some bankers like to keep their effective tax rate at about 20% because the alternative minimum tax (AMT) is around 20%. The average bank in the country is paying over 30% of its pretax income in taxes. These banks have lots of room to reduce their taxes.
These banks could be in the position of a very high-performing BNK client, which is one of the 12 BNKElite banks. Guess what this perennially high-performing bank expects its taxes to be for 2006? The answer: 17%. That’s not a typo. Repeat, 17%!
Marginal Tax Rate
The marginal tax rate is the percentage of tax the bank pays on its last dollar of pretax income. The marginal tax rate is the blend of the federal tax rate of 34% and any applicable state tax rates. That will generally be the highest statutory tax rate. It may be equal to or more than the institution’s effective tax rate. Be careful to differentiate the usually lower effective tax rate from the institution’s marginal tax.
The marginal tax rate is important in the calculation of the Tax and Equity Fiscal Responsibility Act (TEFRA) adjusted tax equivalent yield on the municipal security. The TEFRA formula follows:
TEFRA Yield Adjustment = Cost of Funds x 20% x Institution’s Marginal Tax Rate
Create a Tax Strategy for the Investment Portfolio at Your Community Bank
With the financial institution’s tax rates and current tax-exempt assets in mind, your bank’s executives and directors can begin to create the tax strategy.
Step #1: Calculate the Difference between the AMT and the Regular Tax.
The goal of a high-performance tax strategy should be to lower the regular tax to within a fraction of the AMT. Remember, from a cash flow standpoint, your bank should not create a large ATM to carry forward.
Community bankers and directors often make mistakes in crafting an overall investmentpolicy when it comes to tax-exempt bonds. All too often, community bank directors settle for merely copying policies from consultants and other providers. Many of these policies limit the percentage of each security type that can be held in the portfolio.
A better approach is to study the bank’s balance sheets and tax situations and customize the percentage of tax-exempt bonds to the entire portfolio.
For example, the typical policy may require the financial institution to limit its purchase of tax-exempt securities to 20% of the portfolio. If the institution is high performing, the municipal portfolio may need to be set at a higher percentage of theinvestment portfolio to maximize the institution’s tax strategy. Every community bank is different, so the bank’s executives and directors should customize the policies to meet the specific needs and goals of the bank.
Step #2: Calculate the Taxable Equivalent Yield.
Now, you need to determine the current taxable equivalent yield of the municipal securities that your bank holds in its portfolio. Your investment officer should then make the proper allocation to the tax-exempt municipal portfolio.
The taxable equivalent yield on tax-exempt securities varies depending upon the state in which the bank is located. For the purposes of this discussion, the focus will be on the federal tax level and will not include the state income tax in the yield. However, the investment officer is strongly advised to review the correct taxable equivalent calculation for the financial institution’s particular state with a tax consultant. Calculating the taxable equivalent yield on a tax-exempt security may seem daunting, but it is actually quite easy.
For example, assume the federal tax rate is 34%. The inverse of a federal tax rate of 34% is 66% (0.66). If the tax-exempt municipal security were yielding 5%, under the pre-1986 federal tax rules, the security would yield 7.58%.
5% ÷ 0.66 = 7.58%
Starting with 1986, the federal government set rules to require banks to pay a tax on their tax-exempt securities. This is known as the TEFRA disallowance (TEFRA).
To calculate TEFRA, your bank will need to use its own cost of funds (COF) in the calculation. That’s because the TEFRA disallowance fluctuates up and down with the bank’s COF. If your community bank has a core cost of funds that is typically low, it will have a lower disallowance than an institution with a higher COF.
TEFRA Yield Adjustment = Cost of Funds x 20% x Institution’s Marginal Tax Rate
13.6 bp = 2% x 20% x 34%
If a higher COF is assumed, then the adjustment will be higher.
For example, assume a COF of 4%.
TEFRA Yield Adjustment = 4% x 20% x 34% = 27.2 bp
Because a bank’s COF will vary over the life of the bond, many banks use 25–30 basis points for TEFRA. This rule of thumb typically allows for fluctuations and better budgeting of the taxable equivalent yield on the tax-exempt portfolio. So now, you must subtract the TEFRA disallowance as part of the taxable equivalent calculation.
Using the example of a 5% tax-exempt security, subtract the 30 basis points for TEFRA.
5% - 30 basis points = 5% - 0.30% = 4.70%
The yield of 4.7% is divided by the inverse of a federal tax rate of 34% (0.66), generating a taxable equivalent yield of 7.12%.
4.7% ÷ 0.66 = 0.0712 or 7.12%
Always compare the taxable equivalent yield of tax-exempt municipals to similar risk taxable securities. Especially in the shorter end of the yield curve, tax-exempts mayyield less than taxables. Many portfolio managers look at tax-exempts in a vacuum. As aresult, portfolios frequently contain tax-exempts when U.S. Treasuries would have been a higher-yielding choice.
Step #3: Make Only Bank-Qualified Investments.
Another part of the 1986 tax change for banks involved limiting banks to the purchase of tax-exempt bonds and requiring that new issues of tax-exempt municipal securities have a tax opinion.
You bank’s investment officer may find that a written tax opinion is not available at the time a broker offers a tax-exempt municipal security. To ensure the investment officer meets the responsibility of purchasing bank-qualified investments, several choices are available. The officer can take the word of the broker or, better still, require the broker to fax or email a copy of the description of the bonds from Bloomberg information systems or from other sources, including the underwriter of the security.
Directors must make sure that the investment officer does a post-purchase review. Part of that review includes checking to ensure the bank is in compliance and the necessary tax opinion is in place.
Although it is rare, a bank may have tax-exempt bonds that are not bank-qualified in its portfolio. Unfortunately, in some cases, the compliance and internal audit steps do not ensure that the final prospectus is received.
That is a huge mistake for directors to make. That’s because the bank becomes exposed to the risk of an IRS audit that reveals nonbank-qualified municipal bonds. Of course, IRS audits are not that frequent. Still, the bank must have the prospectus with the bank-qualified opinion attached to prove to the IRS that the tax-exempt securities in the institution’s portfolio are bank-qualified. The IRS will only accept the final prospectus—not Bloomberg pages or other reports.
Huge complications can occur if bonds are found not to be bank-qualified. The most drastic situation is for banks that report to the SEC. In some instances, the SEC has required a financial institution to restate past earnings due to holding nonqualified investments. That can create enormous costs for the institution and embarrassment to the management team.
Add to the Strategic Vision of the Balance Sheet with Municipal Securities
Bank executives and directors must remember that municipal bonds are not merely another investment product from which to choose. Municipal securities can add to the strategic vision for the entire balance sheet because tax-exempt municipal securities can be integral to any bank’s tax strategy.
Moreover, municipal securities can be powerful tools for your bank’s asset-liability management. The long-call features on municipals act as a hedge to the balance sheet that has significant prepayment and call risk.
During a period of falling interest rates, customers focus on refinancing their loans. These are the fundamental asset-liability risks financial institutions must address and manage. Municipal securities can help balance those risks. Municipals can also act as a hedge to a portfolio of prime-based loans and mortgages that are subject to customers who renegotiate their rates lower. The optimal time to buy longer-term tax-exempts is when rates are at or near their peak. That’s where I think we are in the current 2004-06 interest rate cycle.
As interest rates decline, the municipals maintain their yield. While most community banks cannot offset all their risk with municipals, they can develop profitable hedges.
Never Waste Municipals as a Short-Term Investment
With municipals, the investment portfolio will not only be high yielding in lower-rate environments, but it will also provide income to offset the loss of loan income. That is the reason I tell community bankers never to waste tax-exempt municipals as a short-term investment. I think it is a mistake to limit tax-exempt municipal investments to issues with maturities of five years and shorter.
At times, short-term tax-exempt municipal securities have yielded less than similar-dated taxable securities. Remember: With municipals, considering the taxable-equivalent yield analysis is important.
Bank executives and directors need to understand the overall impact that municipal securities can provide. Community banks can use municipal securities to increase investment performance. They also can use municipals in conjunction with creating a tax strategy that will lower their tax burdens and drive overall performance higher.