Wealth Manager

Choosing between inflation and taxes is not much of a choice,
particularly for wealthy investors who typically have a fair share of
assets subject to Uncle Sam’s bite. Fortunately, there’s more than
one way to fight inflation in taxable accounts, as explained by Ben
Thompson, a portfolio manager and one of 11 founding principals
of Samson Capital Advisors, a boutique fixed-income shop in New
York with more than $3 billion under management.

In May 2006, Thompson’s firm began offering its tax-efficient
inflation-protection strategy to clients—primarily high-net-worth
individuals, some of whom come to Samson via wealth managers. The
firm’s strategy marries municipal bonds (and their tax-free coupons) with
a swap, otherwise known as over-thecounter derivatives. The swap here is of
the zero-coupon variety, and its value is linked to the consumer price index
(CPI), a widely used measure of U.S. inflation and the underlying benchmark
for calculating TIPS coupon payments.

The firm’s inflation-protected, tax-efficient strategy is available
through a limited partnership that currently holds nearly $100 million.
The minimum investment is $250,000. Its main selling point:
The strategy strives to lock in a higher inflation-adjusted, after-tax
yield, compared to the after-tax payout of TIPS in taxable accounts.
Samson’s strategy is innovative, but it’s not completely free of
competition. For example, the JP Morgan Tax Aware Real Return Fund
offers a similar product in a mutual fund. In fact, Thompson was a
managing director and head of Tax Aware Fixed Income Investments
at JP Morgan Fleming’s U.S. fixed income group before leaving to help
launch Samson in 2004. A distinguishing characteristic of Samson’s
strategy is that it’s levered to inflation. As a result, returns will beat
TIPS if inflation is higher than expected, or lag TIPS if inflation is
tamer than the market predicts.

Q: What’s the rationale for your tax-efficient inflation-protection strategy?

A: It’s difficult for tax-paying investors to find an inflation-protection
strategy that’s efficient after taxes. TIPS income and inflation
accretion are fully taxable to U.S. taxpayers. Unfortunately, taxes
are quite a significant drag on TIPS returns.

Q: What are the typical tax rates for your high-net-worth clients?

A: Typical rates are 28 percent or 35 percent. The 35 percent rate is the
full marginal rate, and 28 percent is the alternative minimum tax (AMT)
rate. A lot of high-net-worth investors are in the 28 percent AMT rate.

Q: Given those rates, how would a TIPS investment fare in a taxable account?

A: TIPS trade on a real, or inflation-adjusted yield basis. The real
yield subtracted from the nominal yield on a standard Treasury of
the comparable maturity is the break-even inflation rate. If inflation
runs above the break-even rate, then TIPS would be a better
investment [than the comparable nominal Treasury] because the
inflation-related return would be larger than expected.

At the moment [February 8, 2007], the 10-year nominal Treasury
is at about 4.75 percent. The current real yield on the 10-year TIPS is
about 2.40 percent. So the break-even rate is 2.35 percent (4.75 minus
2.40). If inflation runs above 2.35 percent, you’d be better off in TIPS.
If inflation’s below 2.35 percent, you’d be worse off in TIPS.

Let’s say that inflation comes in right at market expectations, or
2.35 percent, as priced by the TIPS market at the moment. The real
yield today with TIPS is 2.40 percent. So, with inflation plus the real
yield, you’ll receive 4.75 percent [2.35 plus 2.40]. To figure what a 35-
percent taxpayer keeps, multiply that yield by 0.65. The 4.75 percent
nominal yield falls to roughly 3.10 percent after taxes.

Assume that the 3.10 percent is what you keep after tax. But you
still have to subtract the inflation of 2.35 percent from that nominal
yield. As a result, the real yield after taxes for investors in the 35 percent
tax bracket drops to 75 basis points. For investors at the 28 percent
rate, the real after-tax yield on the 10-year TIPS is 1.05 percent.

Keep in mind, too, that with TIPS you’re not only taxed on the
real yield, but on the inflation, too. The higher inflation goes, the
greater the tax on the inflation component.

Q: So, TIPS are tax inefficient. What’s the alternative?

A: Before I talk about our approach, I should note that there are
publicly available securities in the municipal bond market that
are inflation-linked and pay tax-free coupons. Unfortunately, the
improvement in real yield [over TIPS] isn’t significant.

Overall, inflation-linked muni debt is still a small sector relative
to the entire muni bond market. One reason is that all of the muni
CPI bonds are hedged in some way back to the TIPS market. No
muni issuer has actually taken inflation risk directly.

Q: How does a CPI swap work?

A: It’s an instrument for trading the break-even inflation rate in TIPS.
Here’s how it works: I enter into a trade with Barclays, Lehman Brothers,
BNP Paribas—counterparties that we use—and I contract to pay
the prevailing fixed rate. In return, they’ll pay me the inflation rate.

Q: So, you’re paying a fixed rate for a CPI swap, determined by market
prices at the time of the trade. In return, the counterparty pays
you a variable rate, depending on inflation. If inflation rises, you’ll
be paid more. If inflation falls, you’ll be paid less.

A: Exactly. I’m taking the same position as the TIPS investor. Today, I’m
locking in an inflation rate of 2.65 percent—that’s what I’m paying out.
If inflation goes above 2.65 percent in the future, I’ll be paid more than I
pay out. If inflation goes below 2.65 percent, I’ll pay more than I get.

Q: Okay, now let’s talk about your firm’s tax-efficient inflationhedged
strategy.

A: We pair a municipal bond with a CPI swap to create a tax-efficient
inflation-linked return. Clients receive tax-free muni bond income
along with an instrument that’s adjusting its payout with inflation.

Q: What maturity are you using for the munis?

A: It’s a little further out than 10 years. The reason is that the muni
bond curve is typically steeper than the taxable curve. As you go
out further in maturity and duration in munis, you get a greater
improvement in income than you do in taxable markets.

Meanwhile, the break-even inflation-rate curve is almost perfectly
flat. If I buy a 10-year TIPS or a 30-year TIPS, the break-even
inflation rate is just about the same. So if I buy a longer muni bond
with a higher yield, I can execute a longer CPI swap but pay no
more for the swap than if I paid for a shorter CPI swap. As a result,
I’m increasing the real yield that’s being earned on the muni.

Q: How does the strategy look with actual numbers from the markets?

A: If I buy a 10-year muni bond today, I could probably buy at a
3.9 percent yield. I can also buy a CPI swap at 2.65 percent, which
includes a bit of a spread over the actual break-even rate. So, 3.9
percent less 2.65 percent is a 1.25 percent real yield.
If I execute those two pieces, I’m going to earn a coupon stream
of 3.9 percent tax free. Meanwhile, I’ve got a comparable-term CPI
swap that pays if inflation rises above 2.65 percent. But I’ll pay if
inflation falls below 2.65 percent. In other words, I’ve effectively
locked in a real yield of 1.25 percent.

Q: That’s an after-tax real yield of 1.25 percent versus your earlier
quote of TIPS’ after-tax real yields of 0.75 percent to 1.05 percent,
depending on the tax bracket.

A: Right. If you move a little further out on the muni bond curve,
you can improve the 1.25 percent real yield dramatically.

Q: Assuming you have a gain in the CPI swap, as you would if inflation
rises higher than expectations, how is the gain taxed?

A: It’s not perfectly tax-efficient. The degree of tax efficiency comes
from the long-term capital gain that would be realized on the CPI
swap. But because it’s a zero-coupon instrument, there’s no current
income—neither side of the swap pays anything before maturity. We
use zero-coupon instruments because we want a pure inflation linkage.

We favor the 15-year part of the yield curve on the CPI swap. We
also purchase options on CPI swaps, which are floors that are similar
to put options that protect against significant declines in value.

Q: So you won’t pay capital gains, if any, on the CPI swap until it matures
in 15 years?

A: Correct, because it’s a zero-coupon. You pay 15 percent on the
amount above the expected inflation rate in a CPI swap. In contrast,
with TIPS, you’re taxed on all of it at the higher ordinary income
rate of 28 percent or 35 percent, depending. Also, with a CPI
payment, your tax payment is deferred.

Q: What else differentiates your strategy from a straight TIPS investment?

A: The level of exposure to inflation in our strategy is amplified relative
to the bond exposure. For every bond, we have four CPI swaps.
By comparison, a one-to-one application—one muni bond and one
CPI swap—has a return and volatility profile similar to TIPS. If you increase
the inflation exposure, you become more and more of a pure
inflation-linked instrument and less of a TIPS-like instrument.

Q: Finally, how does your strategy fit into a larger investment portfolio?

A: If you allocated 10 percent of assets to TIPS, the portfolio is effectively
protecting 10 percent of assets from inflation. Meanwhile, someone
may invest 3 percent to 5 percent of the portfolio in our strategy, and
that 3 to 5 percent carries an amplified exposure to inflation, so it could
conceivably cover 20 percent to 30 percent of a portfolio, or more. So you
put up less capital, but the inflation exposure is amplified.