How the Biggest Problem Facing Investors Was Swept Under the Rug in 1954
Houston....We Have a Problem
There is a ‘Bug’ in the System
Over seventy years ago, financial services companies and investors realized that investors were being over-taxed on the first interest payment they received after purchasing a bond or fixed-income security. That is a BIG problem.
Bonds Trade ‘Dirty’
Investors were being overtaxed on their first interest payment because bond buyers were required to pay the bond sellers the accrued interest earned by the bond up to the time of purchase but could not deduct the accrued interest paid to the seller from the first interest payment they received. This resulted in the buyer paying taxes on “phantom income,” or income that was never earned.
For example, let’s assume I own bonds that pay a $1,000 interest payment every six months. Assuming the market price of this bond is $1,000, and I own 28 bonds, I will sell these bonds for $28,000. However, as the owner, I will also want to be paid the interest earned by the bonds for the time I have held them, calculated since the last bond interest payment was made. Assuming we are three months into a six-month interest payment period, in addition to the $28,000 payment for the bonds, I will also require $500 ($1,000 in interest * (3/6)) in accrued interest. Without charging the seller for the accrued interest the bond earned, I would earn no return on investment for the past three months.
Bond markets refer to the total price of a bond transaction as the ‘dirty price.’ The dirty price is equal to the price of the bonds plus the accrued interest earned and payable to the seller.
However, the bond buyer has a problem. In three months, the buyer will receive the whole $1,000 interest payment and will be taxed on the entire $1,000 in interest at ordinary income rates. Assuming a combined state + federal ordinary income tax rate of 40%, the bond buyer will owe $400 to the IRS and be left with $600 after-tax. But there is a problem… The bond buyer did not actually earn the full $1,000 interest payment because, at the time of purchase, the buyer paid me, the bond seller, $500 in accrued interest(a cash outflow and a cost of the purchase). Therefore, after accounting for the $500 accrued interest payment to me, the buyer actually earned only $500 of income or 3 months of interest, not $1,000. The seller's tax bill on the actual interest the bondholder earned should be $200 or ($500 of interest * 40%), not $400 ($1,000 * 40%).
As you can clearly see, this ‘bug’ in the bond market leads to investors paying twice the taxes they actually owe. That was a big problem.
Devising a Fix in 1954
Because many large institutions deal in fixed-income securities, they devised a simple fix. Since a bond buyer is pre-paying interest income to the seller at the time of sale, the buyer should be able to deduct the interest they paid to the seller from the total interest payment paid by the bond. Claiming this income deduction computes the actual interest earned by the buyer and ensures that the buyer is taxed only on the income they earned. The accrued interest paid is a “cost” associated with the purchase that should be deductible as an expense related to the transaction.
For example, in the example above, the seller would deduct the $500 accused interest paid to me from the $1,000 interest payment they received, resulting in the correct taxable income of $500.
In 1954, market participants implemented this solution and began deducting accrued interest paid to the seller from their first interest payments, effectively solving the problem—but only in the bond markets.
The Bug - Explained
This “bug” in the market is the result of our antiquated payment system, which I am sure worked well in the 1600s, when bonds began to become more mainstream but is wholly inadequate today.
Fact: In any market that is configured to only pay income to “last holders of record,” the buyers of these securities will be over-taxed on their first income distributions. This is because,in last holder of record markets, it is required that the security’s income be included in the price paid. Otherwise, last holder of record markets would malfunction and would be prone to manipulation.
Every stock and bond market in the world operates using this antiquated last holder of record system. A last holder of record payment system is any payment system that is unable to pay sellers their earned income at the time of sale. Therefore, in this type of payment system, 100% of the income earned by the security for a given payment period is payable to the person who owns the security on the last day of the payment period. This is typically the day before the “ex-dividend day” for equity securities.
This means that a seller who has owned a security for 99% of the payment period and sells the security the day before the ex-dividend day earns NOTHING, and the buyer who owns the security for just one day is paid 100% of the income. This makes no sense.
While this may sound like a great deal for the buyer, who earns all the income without actually earning it, it’s not. Remember, since the income was included in the price, both fixed-income and equities investors will end up paying taxes they do not owe unless they account for the accrued income included in the security’s price at the time of purchase as a deductible expense related to the transaction, offsetting the total income received and arriving at the accurate taxable income of the distribution.
Equities Trade Dirty, Too
As discussed in a previous Substack titled “Buying a Dividend—What it is and Why it Matters,” we established that, like bonds, the income of an equity security is included in the security’s value.
Just like bonds, equities trade dirty too.
Market participants realized equities were also problematic when they devised a fix for the bond markets.
Therefore, the trillion dollar question is: If they recognized these issues seventy years ago when they fixed the bond markets in 1954, why didn’t they fix the equities markets, too? After all, they realized the problem existed in both markets.
I am not sure we will ever get an answer to that question. Perhaps it is because the bond markets traded much slower than equity markets, and an intermediary was able to write up the accrued interest at the time of purchase. Perhaps the technology wasn’t available at the time? We will probably never know. So how did market participants address the open problem of over-taxation in the equities markets?
Why Don’t Investors Know About This Problem?
When market participants addressed issues in the bond markets, they should have taken the opportunity to educate investors about the risks in the equities markets as well. Specifically, investors needed to understand that "equities trade dirty too," meaning they will incur losses when purchasing these securities in taxable accounts.
By providing investors with the necessary tools and knowledge, they could better comprehend these risks and employ various strategies to mitigate them, thus protecting themselves from potential losses.
Disclosure laws, such as those mandated by the Securities Act of 1933 and the Securities Exchange Act of 1934, form the bedrock of securities regulations. These laws ensure that investors have access to all relevant information needed to make informed decisions. Compliance with these disclosure requirements is not optional; they are fundamental to maintaining transparency and integrity in the financial markets.
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Call to Action - How You Can Help
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