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Fun with international bonds a.k.a. The frog begins to boil 
4th-Oct-2005 01:44 am
money

He tore the golden brooches that upheld
Her queenly robes, upraised them high and smote
Full on his eye-balls, uttering words like these:
"No more shall ye behold such sights of woe,
Deeds I have suffered and myself have wrought;
Henceforward quenched in darkness shall ye see
Those ye should ne'er have seen; now blind to those
Whom, when I saw, I vainly yearned to know."

Sophocles, "Oedipus Rex"

It's one thing if the 1040 instructions are telling you something like "See Pub. 550 for details; if you don't meet the following conditions you'll have to use the worksheet there."

It's quite another if you're already in some publication or other and they say, "See regulation 1.988-2(b) for details," which roughly translates to "Worksheet? Hahahahahahahahahahahahahahahahahahahaha. No."

Today's topic:  Foreign-currency-denominated bonds.

It's really shouldn't be that complicated.

You loan somebody money. Sometime later the money comes back and maybe there are interest payments along the way, too. Interest goes on Schedule B, and if what you get back is somehow different from what you paid out in the first place, that's capital gain/loss, which goes on Schedule D. Just like when you buy a stock and sell it again and maybe it pays dividends along the way. Right?

Well, yes. Maybe. But only under very limited circumstances that almost never arise in real life.

The first small matter is that the "somebody" here might be General Motors Corporation or the State of North Carolina, meaning you don't actually get to sit down with them and hammer out the terms of the loan.

'Twould be fun, I suppose ("so um,... we've reviewed your credit history and I see here that you were late with a payment back in June of 1993. We'll need a letter explaining this, before we can approve your application. Not a big deal, perhaps, but we got up on the wrong side of the bed this morning and want to see you grovel a bit."). Unfortunately, or maybe fortunately, somebody else gets to do that.

Or, rather, somebody else already did that, say, back in 1995. And so GM or NC or whoever has been happily coasting along for the past 10 years, paying back this loan. And then here you come, walking through the mall, passing by the cute little Bond Shop tucked away between ToysRUs and the Scotch Tape Store. Something pretty with a good credit rating and a nice yield catches your eye. You go in and say to the proprietor, "Ooo, that looks nice; I'll take that one of those."

This being a supposedly free market and all, there's no law that says what you pay for the bond need have anything to do with what General Motors or the North Carolina is expected to be paying back 10 years from now, the latter being referred to as the "par value" or "face value" of the bond. Interest rates fluctuate; the money supply changes; shit happens.

Now it could just so happen that the price you pay matches the face value of the bond, in which case, yes, it's almost exactly like buying a stock that pays dividends (except, of course for being interest, not dividends).

Having now dispatched that completely-trivial-hardly-ever-happens case, we're left with two others:
  • You can pay more than par, i.e., par plus a premium. Meaning interest rates have gone down since the bond was issued, that the bond thus pays too much interest, and is, therefore, in the current market, actually worth more than its face value, and you pay extra accordingly.
    I should note that, at this point, the IRS gives you this little intelligence test. The default treatment of premium bonds is, in fact, the "just-like-a-stock" treatment as above, i.e., you report the interest on Schedule B, pay tax on all of it, and then, 10 years from now when you get the par value back, the premium becomes this (possibly large) long-term capital loss that cancels out some of your other long-term capital gains. Meaning you've taken money that will be taxed 10 years from now at the 5%/15% long-term capital gains rate and taxing it now at the (larger) ordinary rate. Bad idea.

    In order to not do this you have to explicitly elect to "amortize bond premium" and thus get the treatment I'm about to describe, which is way better.

    It's interesting to note, by the way, that in the case of tax-exempt bonds, there's a separate rule requiring you to amortize bond premium, because, with the ordinary tax rate for interest in this case being zero vs. a capital gains rate that's still positive, the stupid treatment now works to the IRS's disadvantage, and, well, we can't have that, can we?
    The Right way to handle premium bonds is to make the election that allows you to deem a portion of each "interest" payment to not actually be interest but rather a chunk of the premium you paid that is being returned to you. Over the course of 10 years, premium comes back in little dribs and drabs like this, each of which reduces your cost basis in the bond, until finally, the bond comes due, and it just so happens that the basis at this point has reached par, which also happens to match the final principle payment, i.e., the proceeds from the final "sale" of the bond. No loss, no gain, no pain.

    Just like when you make a mortgage payment, part of what you pay is interest, the rest is paying down the loan, except instead of you having 30 years to pay your loan down to zero, it's them having 10 years to pay their loan down to par.

    Of course, the folks actually paying the money don't know anything about this. They don't give a crap how you acquired the bond or what your premium was. They're just making payments which are all of an amount that was fixed 10 years ago. The only reason they even know you exist is because they need a destination to send the money. Figuring out what it all means is your problem.

    So how do we tell how much of a given "interest" payment is really interest? Simple enough: it's the amount owed times the interest rate. Which is a nice way of begging the question; we already know that the interest rate printed on the bond is wrong. There is a real interest rate somewhere, though. We don't know what it is yet, but we can solve for it.

    Consider it this way:
    You've paid some amount to acquire the bond; this is your basis.
    Somebody now owes you that amount of money (i.e., par+premium).
    Multiplying your basis by the "true" interest rate R tells you what interest you're owed for a given period.
    Oh, wait, they paid you too much; funny that.
    No matter, just subtract the overpayment from your old basis to get your new basis for the next period.

    Wash, rinse, repeat for 10 years.

    At the end of this, if the R you picked really was the One True Rate, your basis should now be par. If the payments are semi-annual (which is typical for bonds), this gives you a 20th-degree polynomial equation in R that you can solve. This polynomial happens to be in a particularly nice form, namely that of a geometric series which collapses into a quite manageable expression -- crack open your Algebra 2 text if you don't believe me. Attack with Newton's method and you're done. You now have a number for the "true" rate R, otherwise known as the "yield".
    And then you go back and do the multiplications to get the amounts of all of those stupid overpayments, otherwise known as "amortized bond premium (ABP) adjustments."

    Finally, you add up all of your ABP adjustments for the year for all of your bonds,
    put it on a single line on schedule B and subtract. Done.
That was the easy case.

We next proceed to the other possibility:
  • You can pay less than par, i.e., par minus a discount. Meaning interest rates have gone up since the bond was issued -- or maybe the bond was issued at a discount in the first place because the loanee, for whatever reason, wanted smaller payments and a final balloon instead. The bond thus pays too little interest, and is, therefore, in the current market, worth less than its face value.

    Just the reverse of the previous situation, you'd think. Again, you are owed a certain amount of money. At the end of each period, you get interest. But wait, they've stiffed you. Assholes! Oh well, we'll just increase the amount they owe and keep going; compound it for next time; mwahahahahahaha. Your basis increases. And again, assuming you've done the yield calculation right, 10 years from now your basis will reach par and there's no gain or loss.

    This time, though, since each interest payment is an underpayment, you now have to add stuff to Schedule B to make up the difference, i.e., your basis is increasing, therefore you must be getting income. And, rather like the interest you get on a bank CD, you still have to pay tax on it as you go even if it's not anything you can "withdraw" (well okay, you can always sell the bond but if you do, then you're open to market screwage...), which is perhaps a bit annoying, but I'm just getting warmed up, here...

    Fly in the Ointment #1 is that, for some reason I can't fathom, the Congress/IRS have decided that it's really the discount with which the bond was originally issued (i.e., price on day 1 is less than par), meaning that, with respect to the price you actually pay for the bond, things now have to be broken out into 3 cases:

    1. The (rare) "easy" case in which the price you paid happens to match the original issue basis. That is, you imagine someone having held the bond from day 1 to the day you bought it, and your price exactly matched whatever his final basis was. Which means we're back (almost) to the simple world of ABP. That is, you solve for the yield as before, figure out the underpayments for each interest payment you're destined to receive, and those become "original issue discount (OID) adjustments", which then increase your basis and you pay interest tax on those in addition to the tax you pay on the interest you actually receive.

      Which leads us to Fly in the Ointment #2, which is that in this OID world, it's not enough for the money to show up at the end of the period the way ABP does. The Congress/IRS wants that income appearing on the books now now now, so they've decided it should accrue daily, meaning all of those little dribs and drabs of OID-showing-up-as-income-every-six-months are now being divided by 180 (or whatever the length of the period is) and showing up that much more often.

    2. If you pay more than the original issue basis but less than par, you have what is called an "acquisition premium" which then, in a strangely linear fashion, proportionally reduces the OID tax from what you'd otherwise have to pay. So, e.g,. if it's a $10,000 face value, the original issue basis at the time you buy is $9000 and you actually pay $9500 for the bond, then reduce all of your upcoming OID adjustments by half. (Yeah, sure, whatever...).

    3. If you pay less than the original issue basis, the additional discount (called "market discount") now just sits there while you accrue OID as in the first case. When you dispose of the bond, either at maturity or by selling it, the market discount becomes part of your capital gain/loss -- unless it's a tax-exempt bond, in which case it becomes taxable interest income (WTFF? Thank you, 1993 Congress).

    As it happens there are a bazillion different elections you can make here, but I won't burden you.
There is one more wrinkle. Since you're most likely buying the bond in the middle of an interest period, there will be a previous owner who is expecting to get interest for that part of the period during which s/he owned the bond and that's your problem. Meaning when you buy the bond, you make a separate payment of the interest due the previous owner. You do get it back when the period ends and the first payment addressed to you finally arrives. And this is yet something else (the "Accrued Interest Adjustment") to subtract on Schedule B.

So, where was I? Oh, right; foreign-currency bonds.

Well it seemed like a really cool idea, I mean, the dollar's going into the toilet, so best to park the money somewhere else. And since the stock market is probably about to tank, and foreign stocks are going to be dicey even in the best of circumstances, and income is useful to have, bonds are sort of the Obvious Thing here.

Meaning instead of the State of North Carolina or General Motors, it's now the German Bundesbankwhatever or the Government of HRH Elizabeth 2R Defender of the Faith, Dragonslayer and Whatever Else -- yes, she owes me money; I send my goons by every six months to collect; it's great fun.

Problem is IRS wants everything in dollars. HRH doesn't do dollars. What now?

Welcome to Section 988 of the Internal Revenue Code.

To make a long story short, we have exchange rates. Go us.
At least with British pounds there is this (vast) market between dollars and pounds and thus rates are being set every day. Whatever you do, do not look at the rules for how you establish an exchange rate if it's the hyperinflationary Lower Slobovian Mwrkt that only gets traded once in a blue moon. Waking up in a blue haze hours later with most of your furniture destroyed? Not fun.

The First Rule of 988 is that every transaction is a dollar transaction. So while you thought you had
  1. changed a bunch of dollars to pounds
  2. bought a bond with the pounds
  3. paid the accrued interest in pounds
  4. (later) received your first interest payment in pounds and changed those pounds to dollars
  5. (later still) received the 2nd interest payment...
etc., this is not so. Actually what you really did (and we'll do the easy premium bond case here) was
  1. bought some pounds (which now have a dollar basis)
  2. paid for the bond, or, rather
    1. sold some pounds (we now have an exchange gain/loss) and
    2. used the proceeds to buy the bond with dollars. Since the bond is a pound-denominated asset, this means we've turned dollars back into pounds, which now have a new dollar basis
  3. paid the accrued interest, or, rather,
    1. sold some more pounds (another exchange gain/loss) and
    2. used the proceeds to pay the accrued interest, which turns out to be yet another pound asset with a dollar basis
  4. (later) received your first interest payment as a dollar amount that breaks down five ways:
    1. the actual interest income
    2. the accrued intest being returned
    3. the exchange gain/loss on the accrued interest
    4. the ABP being returned
    5. the exchange gain/loss on the ABP
  5. (later still) received the 2nd interest payment, which admittedly only breaks down into three parts now that the accrued interest is taken care of, but still...
4a, 4b, and 4d all go on schedule B as before, while 2a, 3a, 4c, and 4e all go into the exchange gain/loss column on your 1040 which is, (drumroll...)

... well,...

nowhere. Line 21 ("Other Income"), it is, then. Yesssss!

Oops it's actually a loss. Well we can still put it there; it's not like there's anywhere else.

The other fun part in all of this is that if you're receiving interest in pounds and not immediately converting them back to dollars, then you have all of these little odd lots of pounds for which you now have to track the bases for the purposes of computing exchange gain/loss when you use/spend them later on. At least there's no notion of long-term vs. short-term, so you don't actually have to remember the dates, but bleah.

Did I say premium bonds were the easy case? You bet. Foreign-currency bonds with original-issue discount are a Seething pit of Hell, and I do not use this phrase lightly.

Remember how with domestic OID bonds, you've got little teentsy bits of OID accruing every single day? That rule still applies. Except that now, you compute it in pounds and report it as dollars using whatever the exchange rate was for that day. Then those pounds become part of the basis, but you still have to remember that dollar amount because, years later, when the bond comes due or you sell and thus finally receive said pounds in your grubby paws, you will have exchange gain/loss on that bit of poundage and likewise for each of the other thousands of components of OID that comprise the final basis.

Meaning, yes, you have to know the exchange rate for every single day of the period during which you own the bond. I am not making this up.

Granted, there are short cuts in that if you've held the bond for a full month or a full year, and somebody has helpfully computed an average exchange rate for that month or year, then you're not actually doing all of those daily calculations; but you've still got work to do when purchases, sales or interest payments fall in the middle of the month the month, which, um, tends to happens 29 times out of 30.

Suffice it say, I'm eternally grateful that my broker has yet to sell me an OID foreign bond.


And then of course we have certain whackjob governments like Australia who do 10% withholding on interest payments. Which then puts us in Form 1116 Hell in order to get that back.

Form 1116, in case you didn't know, is where you do the miniature 1040 that's Just For Australia. That is, you (sort of) figure how much tax you would have paid if Australian taxes were exactly proportional to US taxes. This then sets an upper limit on how much the IRS is willing to allow you as a tax credit for the money you've paid Australia.

Repeat for every other country you're getting income from.

Which gets to be particular fun in our case because we have this one mutual fund that does business in 22 countries and does the see-thru election whereby you can actually know income and tax payments for each. Which I suppose is better than the usual case where they just pay the tax, bury it in their expenses and there's nothing you can do about it.

But damn. 8 pages to do 23 countries. Good thing I have a computer, I guess.

Oh hey, $14.06 of income from the Republic of Vietnam. Go us.

At this point, I almost want to get audited because otherwise all of this effort goes to waste. No, wait, I did not just say that.

Just in case you were wondering, all exchange gains/loss are explicitly deemed by statute to be US source, meaning none of it counts towards raising the ceiling on foreign tax credit allowed -- even though one could make a fairly good case that exchange losses ought to be allocable as expenses towards the production of foreign source income -- figure that one out.

Oh, well. At least this year, the Alternate Federal Government doesn't actually want more money than the real one. Yay for that.
Comments 
4th-Oct-2005 06:23 pm (UTC)
I'll admit to skimming most of this, but all I can say is this makes me yearn for a simple tax system where all income is taxed at a single rate with a single standard exemption and no deductions.

Investors would be screwed compared to now, because they wouldn't get any tax breaks for their kind of income. On the other hand, they wouldn't have to deal with the nightmare of complicated taxes. CPAs would all be out of work, but is that really such a loss?

As for foreign currency exchange, I don't know why you can't just buy pound-denominated stocks/bonds or some equivalent (and trade for other securities in pounds without any additional exchange) and pay income taxes in either dollars at tax-time exchange rates, or pounds if you prefer. It seems ludicrous to require forced exchanges throughout the process, making a nightmare of what should be really simple. Somebody's got to be making money out of the arrangement, and it seems like it's everybody but the small investors and regular taxpayers.
24th-Oct-2005 04:23 am (UTC) - Fun with international bonds :)
HA HA HA HA! You are funny.
1st-Nov-2005 06:06 am (UTC) - Re: Fun with international bonds :)
we aim to please.

but if you were hoping for an exposition on The Straddle Rules, that's going to be a while.
13th-Apr-2011 08:28 pm (UTC) - Looking forward to get involved
Anonymous
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