An obscure provision in the tax-increase bill passed by the House last month is sending tremors through the bond markets.
The provision, which would speed up collection of taxes on bonds that sell for less than their face value, is not included in the Senate version of tax legislation. Congressional sources say it may not survive in the final, compromise tax increase that Congress expects to pass this year.
But bond traders and other industry officials say the proposal is causing higher interest rates, reducing the value of outstanding bonds, shrinking activity in the market and raising investor concern.
"There clearly is disruption in the secondary market," said Jim Hearty, managing director for First National Bank of Boston, referring to the resale market. "There are fewer bids than there should be and the bids that are there are reduced."
The provision covers taxable and tax-exempt bonds. It would affect only bonds that are sold after Oct. 13, 1986, but traders say it would reduce the overall value of outstanding previously issued bonds because so many are subject to resale.
Under current law, investors who buy bonds at less than their face value can delay paying tax on the capital gain -- the difference between the price paid and the face value of the bond -- until the bond matures. (Bonds generally trade at less than face value when market interest rates are higher than the interest rate paid by the bond). The House plan would tax a portion of that assumed gain each year. If a $1,000 10-year bond was bought for $900, for instance, the investor would have to pay tax on $10 a year for 10 years to make up the $100 gain. In theory, the total tax owed would not change, but it would be owed sooner than it is now.
Industry officials complain that the buyer would be taxed on money that he or she would not receive for years to come, and could never receive if the bond were resold before maturity. The investor could take a tax loss if he had paid tax on an amount greater than the subsequent selling price. Keeping track of those fluctuations, and other details necessary to implement the provision, would require extensive record keeping, industry experts said.
The proposal would cover bonds whose interest is exempt from tax, such as those issued by states and municipalities, and taxable bonds, such as those issued by corporations and the U.S. Treasury.
According to the investment banking firm of John Nuveen & Co., about $500 billion of the roughly $700 billion in outstanding municipal tax-exempt bonds is paying interest at rates below those on currently issued bonds, thus making them potentially subject to the provision.
A similar proportion of the $600 billion in outstanding corporate bonds and the $250 billion in outstanding U.S. Treasury bonds could be covered by the provision, the firm said.
So far, the proposal -- disclosed last week by The Bond Buyer, a trade publication -- has upset industry officials, but it is only beginning to have a substantive impact on the market. Jim Wesolowski, vice president and assistant general counsel of Nuveen, said one recent sale of discount bonds took place at an interest rate 0.2 percentage point higher than traders expected.