Interest rates are up, and bond prices are down. That’s revived a long-dormant tax-deferral opportunity for buyers of individual bonds. KIERSTEN ESSENPREIS By Laura Saunders July 21, 2023 5:30 am ET Apple’s AAPL -0.62%decrease; red down pointing triangle stock is near all-time highs and the company’s market value has topped $3 trillion. Yet some of its debt is trading at prices ranging from around 69 cents to 84 cents on the dollar. Typically, such a mismatch would signal a sharp divergence between what stock and bondholders think of a company’s prospects. In this case, the hobbled debt prices reflect drastic changes in interest-rates. The great interest-rate reset of 2022 caused by the Federal Reserve’s campaign to squash inflation brought carnage to the bond market. That has left debt sold by a wide swath of high-quality companies, and even the U.S. government, trading at big discounts to its face, or par, value. This brings rare tax-deferral opportunities—and a potential pitfall—to buyers of individual bonds. For higher-income investors, the ability to push taxable income into the future can be a boon, especially if they expect lower overall income in coming years taxed at lower rates. Many investors aren’t aware of these tax effects because interest rates have fallen for decades and until recently were at superlow levels. In addition, advisers often recommend holding bonds in tax-deferred retirement accounts like IRAs and 401(k)s, because bond interest is taxed at ordinary-income rates. Currently the top federal rate on interest is 40.8%, while the top rate on many stock dividends is 23.8%. Still, plenty of investors hold individual bonds in taxable accounts, whether for diversification, current income or cash management. With the great rate reset, many can defer tax on a chunk of their returns on purchases of bonds trading at a discount. “The increase in interest rates has caught people by surprise, so they need to know about options they haven’t considered for a long time,” says Tim Steffen, a CPA and director of advanced planning at investment firm Baird. Here are bond facts to keep in mind: When interest rates rise, the prices of existing bonds with lower interest rates, or coupons, typically fall to provide a higher return, or yield, to attract buyers. The amount the bond price falls from the face amount is known as the discount. Typically, prices of debt that doesn’t mature for a longer time fall more. Take, for example, an Apple bond with a face value of $1,000 and coupon interest of 1.65% coming due in 2030. Comparable Treasurys currently yield around 3.9%. Because of the difference, investors demand a lower price for the Apple bond, which was recently around 84 cents on the dollar, according to MarketAxess. That discount, along with the coupon interest, results in a competitive yield of about 4.4%. If an investor buys the bond now and holds to maturity, he will receive interest payments totaling about $116 plus about $160 due to the discount. As a result, the income from the discount will be more than half the total return on the Apple bond. Now for the tax break: The investor owes tax on the bond’s coupon interest annually, but he can choose how to treat taxes on the discount. Either he takes it into income bit by bit over the life of the bond, or he can defer it until the bond matures. The latter is a welcome outcome, says financial adviser Allan Roth of Colorado Springs, Colo. “Investors can defer taxes on stocks, but not usually on bonds.” Unless the discount is very small, the income from it will be taxed at ordinary rates. How small? According to IRS Publication 550, it must be less than 0.25% of the bond’s face value times the number of years remaining until maturity. On a bond maturing in 10 years, that’s a price of more than $975 and less than $1,000, according to Roth. If this exception applies, the income from the discount counts as a capital gain. Note that the deferral isn’t available when a bond is bought at 100 cents on the dollar, because there’s no price discount. Given the interest-rate surge, however, many bonds are selling at discounts. In general, says Steffen, the lower the coupon and the more time left until the bond matures, the greater the discount will be—and also the risk if the investor guesses wrong about interest rates. In Apple’s case, a bond it issued with a 2.65% coupon that doesn’t come due until 2051 recently traded at around 69 cents on the dollar, according to MarketAxess. Microsoft debt coming due in 2062 with a coupon of 3.041% was around 72 cents. There are also discounts on shorter-dated debt, although these are less. Alphabet debt due in 2027 with a 0.8% coupon was around 87 cents. Johnson & Johnson bonds with a 1.3% coupon that come due in 2030 were trading around 82 cents. Corporate bonds typically trade at higher yields than U.S. government bonds, reflecting higher credit risks. But even some government debt now has large discounts. Recently, a 30-year Treasury bond issued in 2020 was trading at around 55 cents on the dollar, according to Tradeweb. Its coupon of 1.25% is well below the roughly 3.9% yield for the most recently issued benchmark 30-year bond. An investor buying the older Treasury who holds to maturity could defer tax on nearly 60% of the bond’s total return. With discounted Treasurys, the tax-deferral benefit is in addition to a better-known tax break—exemption from state and local income taxes. This can boost returns, especially for investors in high-tax states like California, Minnesota, New York, New Jersey and Massachusetts. Investors in tax-free municipal bonds should beware of a pitfall, however. The same rules that benefit investors in corporates and Treasurys can trap muni buyers. For them, the discount income above a minimal amount (as described above) is taxable at ordinary-income rates—and that turns a tax-free bond into one that’s partly taxable. What happens if interest rates reverse again and bond prices rise? In that case, investors selling discounted bonds at a profit will likely have taxable income. But that’s a complicated topic for another day. For now, investors sifting through the bond-market rubble can find some tax opportunities.