When TEFRA was enacted, a BQ muni issuer bringing $10 million to market was a considerable issue size, and these issuers made up approximately 30% of the entire municipal bond market. Today, the $10 million limit has not increased with inflation, so the BQ share of the entire tax-exempt muni market has declined to less than 5% of the total municipal bond market. Banks purchasing BQ bonds pay a premium to do so because there is such a limited supply of these BQ issued. Tis premium, due to bank demand exceeding available supply of BQ munis, has created a permanent yield advantage for GM munis. Te yield differential for comparable maturities and credit quality BQ munis versus GM munis is generally 25-50 basis points.
Beyond a significantly better yield, the GM municipal market is superior to the BQ muni market in other aspects. Te GM muni market is considerably larger, which creates greater liquidity and provides an opportunity to create a more diversified municipal portfolio because there is a much larger pool of municipalities that issue GM muni bonds. Te larger pool also provides a significantly larger population of bonds with higher agency ratings. Also, GMs are not limited to the $10 million annual issuance limit that applies to BQs, giving banks the opportunity to purchase larger block sizes. Without this, most regional banks have avoided building large municipal bond portfolios. Finally, these bigger, more sophisticated municipalities with larger issues provide more complete, transparent and timely financial data to investors and ratings agencies.
Tis additional yield has enticed community banks to purchase GM munis throughout the past 10 years. During the same time period, banks have experienced a relatively low cost of funds, so banks have taken advantage of the steep municipal bond muni curve with less concern about how the TEFRA penalty could degrade their tax equivalent yield. Now, with the prospects of “higher for longer” interest rates, the penalty can meaningfully reduce a bank’s effective yield on new or existing GM municipal holdings.
AN INVESTMENT SUBSIDIARY SOLUTION In the current interest rate environment, banks are unable and unwilling to sell their GM munis and recognize losses. And as banks’ cost of funds continues to increase, the larger TEFRA penalty will greatly reduce the tax equivalent yield on a bank’s GM muni portfolio. One solution is for a community bank to form a wholly-owned subsidiary to hold their GM municipals — a General Market Investment Subsidiary. In 2007, the U.S. tax court ruled in PSB Holdings v. Commissioner of Internal Revenue that a bank investment subsidiary is not itself a “bank” and therefore is not subject to the TEFRA haircut for BQ or GM munis. Tis case resulted in banks with investment subs revisiting GM munis as a potential sector for investment. Te court noted that other than simply avoiding the TEFRA haircut, a bank must have a business purpose or reason for forming an investment sub, e.g., minimizing state taxes. Te investment sub allows a bank to consolidate management of the investment portfolio, provide access to highly skilled investment officers (through the service provider it hired to manage its investment subsidiary) and provide greater purchasing power for portfolio services like custody and bond accounting.
DECISION TO FORM A GMI SUBSIDIARY Banks have been using investment subsidiaries for decades. In the current market environment, many banks may look to municipal bonds to enhance the yield of their portfolio. Banks with muni portfolios should evaluate forming an investment sub so that they can hold and build a GM muni portfolio. Interested community banks should always consult with their tax advisors and with professionals experienced with forming and managing investment subs for banks.
for the KeyState Companies. He oversees KeyState’s Investment Advisory and Bank Investment Subsidiary group with more than $12 billion in in 1991, KeyState manages tax advantaged investment and insurance
lwood@key-state.com or visit key-
state.com. KeyState is an MBA endorsed partner.
KeyState is not a tax advisor; please consult your bank’s tax advisor before proceeding with any strategy.
THE MISSOURI BANKER 19
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