‘Tax-Free’ Muni Notes May Not Be Entirely So

California municipal money market funds and other investors have a potential multibillion-dollar problem on their hands, and the only thing most of the parties involved can do is point fingers at one another.

In an extraordinarily embarrassing episode for everyone concerned, an as-yet-unknown number of California tax-free money funds since spring have invested in short-term notes that may not be entirely tax-free. Individual investors who bought the notes may be in the same predicament.

The securities--typically known as tax and revenue anticipation notes, or TRANs--are issued each year by counties, school districts and other municipalities as a way to borrow in advance on revenue that will accrue during the fiscal year.

The interest paid on these notes, as on almost all municipal securities, is free of federal income tax. But the Internal Revenue Service has in recent years changed the rules regarding the issuance of these securities, to make sure that the issuers and investors don’t derive more tax-free benefit than a “fair” muni yield should offer.


One of the big IRS-ordered changes took effect last year, aiming at a favorite practice of California municipalities: issuing $1,000 notes for, say, $1,020, with relatively high coupons and 13-month terms. Such deals gave the issuers more money up front and provided lucrative returns for the investors.


A full explanation of the IRS rule change would bore most people to tears, but in a nutshell the feds said that depending on the type of muni note you buy, and the price you pay relative to its original issue price, you may owe ordinary income tax on the difference. In bond market shorthand, if you pay $101 for a note issued at $102 and worth $100 at maturity, you could owe tax on the $1 difference between $101 and $102--however unfair that might seem.

For a tax-free money market fund, the thought of owing any taxes is naturally abhorrent. Which means the funds should have been very careful in buying TRANs this year.


But they weren’t, and apparently neither were a lot of other buyers of these securities. Why not? Astonishing as this sounds, no one among the highly paid crowd of investment bankers, lawyers, mutual fund managers and others involved was aware of the IRS rules until late July.

“Everyone was asleep,” says one California state finance official. “Everyone assumed someone else was doing ‘due diligence’ on these deals.”

The problems affect TRAN investors nationwide, but California localities in particular have been fond of this type of financing vehicle. And we aren’t talking about a few dollars: More than $3.4 billion in California TRANs was issued through June this year.

Though not all of them are subject to the tax rules (notes issued for one year or less aren’t affected), the issuers whose 1994 notes are potentially “tax-disadvantaged” include Contra Costa County, Ventura County, San Francisco County and the L.A. Unified School District.



California tax-free money funds, whose assets now total about $14.5 billion, hold much but certainly not all of this paper. The fund managers, understandably, are livid because they say nobody told them about the tax issue. They blame the underwriters of the notes (major brokerages) and the underwriters’ lawyers, who are paid to issue legal opinions on the securities’ tax ramifications.

“I would guess there’s some negligence there,” says Pam Wisehaupt, whose Vanguard California Tax Free fund has 2.5% of its assets in TRANs.

But the lawyers note that the IRS rules apply only to investors who purchase TRANs after they begin trading. In other words, investors who bought directly from the issuers at the initial sale don’t have a tax liability--only “secondary” buyers do.


“Our response is that disclosure (required) with regard to tax issues is for the original investors,” says Jan Brockman, partner at the bond counsel law firm of Orrick, Herrington & Sutcliffe in San Francisco. Counsel, she says, has no legal requirement to advise secondary buyers on taxes, at least not in the offering documents.

Unfortunately, the IRS rules do affect original buyers, because the notes in question have dropped sharply in value precisely because of the tax threat. Many TRANs were issued at annualized yields of about 3.6% in spring; today the market is demanding 4.5% to 4.6%, so the principal value of the TRANs has fallen accordingly.

For muni money funds that own TRANs, the decline in the notes’ prices has raised the question of whether principal losses must be reflected in the portfolios--and whether those losses could be large enough to then require a reduction in any fund’s normally stable share price of $1. Obviously, any money fund that “breaks” the $1 share price would see shareholders stampede out.

The good news: For most funds it appears that the notes don’t make up enough of their assets to threaten the share price. Wisehaupt says her 2.5% stake is “nothing we’re concerned about.” At Wells Fargo, which runs the Stagecoach and Overland muni money funds, TRANs are “significantly under 5%" of assets and aren’t a problem, says manager David Wines in San Francisco.



But whether the entire California money fund universe will escape share price turmoil remains to be seen. Federal regulators say privately that they don’t know of any funds whose $1 price is in jeopardy from TRAN losses, but they concede it may be too early to say.

The chart below lists the biggest California muni money funds. The only clue for shareholders that a fund may have a large stake in TRANs is the “average maturity”: The longer that maturity, the greater the chance that 13-month TRAN paper is in the portfolio, because TRANs of that term would tend to skew the maturity to the long end.

But note: A long average maturity isn’t a sure sign of TRAN investments. What’s more, it’s a good bet that any of the major mutual fund companies or brokerages wouldn’t permit their money funds to break $1 anyway. As with some well-publicized bond fund debacles last spring, big fund sponsors would most likely inject capital into their money funds to protect the $1 share price and avoid a public relations nightmare.


However this sad episode plays out, at the very least it is another reminder to investors that “risk” can exist even where you least expect it. And it’s also another wake-up call for the fund industry, which seems to be forgetting what “due diligence” in investing is all about.

California Tax-Free Money Funds

Assets, maturities and yields of some major tax-free money funds with assets of $100 million or more that are available to individual investors and designated for California residents (for periods ended Aug. 8):

Average 7-day maturity cmpd. Fund Assets (days) yield Alliance Muni Trust/CA Port. 219.8 87 2.2 Benham CA Municipal 245.0 50 2.4 Benham CA Tax-Free 379.8 50 2.4 CA Daily Tax-Free Income 127.3 89 2.4 CMA CA Muni. Money Fund 1,200.4 87 2.4 Calvert T-F Reserves/CA 296.3 6 2.5 Dean Witter/Active Assets CA 311.4 61 2.2 Dean Witter/CA T-F Daily Inc. 260.4 65 2.3 Dreyfus CA Tax-Exempt 294.7 73 2.4 Fidelity CA Tax-Free 668.2 38 2.4 Fidelity Spartan CA Muni 1,205.6 39 2.7 Franklin CA Tax-Exempt 704.7 55 2.2 General CA Municipal 677.7 75 2.7 HighMark CA T-F Fund/Cl B 117.8 64 2.4 Kidder Peabody CA T-E 188.4 68 2.2 Merrill Lynch CMA CA 1,201.0 87 2.4 Nuveen CA Tax-Free 159.1 39 2.4 Overland Express CA T-F 318.4 45 2.2 Pacific Horizon Shrs CA T-E 204.1 46 2.3 PaineWebber RMA CA Muni 309.9 63 2.2 Provident Inst. Muni CA 417.9 66 2.8 Prudential/CA Muni 317.8 59 2.3 Schwab CA Tax-Exempt 1,241.9 62 2.3 Smith Barney Muni. CA/A 208.9 49 2.3 Smith Barney Shs. CA Muni 814.7 51 2.3 Stagecoach CA Tax-Free 834.1 45 2.2 USAA Tax Exempt CA 249.3 58 2.6 Vanguard CA Tax-Free 1,090.1 56 2.6


Source: IBC/Donoghue

Borrowing Short

California counties, school districts and other local issuers have increasingly used short-term “tax and revenue anticipation notes” to finance operations. Volumes since 1985:

Number Value of issues Year of issues (in billions) 1985 166 $1.839 1986 156 2.837 1987 167 2.078 1988 188 3.109 1989 242 2.970 1990 310 2.953 1991 409 4.063 1992 493 6.057 1993 623 9.826 1994* 441 3.440


* Data through June 30

Source: California Debt Advisory Commission