Bond Washing: What it is, How it Works in Fixed Income

What Is Bond Washing?

Bond washing is the practice of selling a bond just before it pays a coupon payment and then buying it back once the coupon has been paid. Bond washing previously could result in apparently tax-free capital gains because after the coupon has been paid, the bond will often sell for less. However, the practice has been banned in most major jurisdictions.

How Bond Washing Works

Bond issuers make periodic interest payments, called coupons, to bondholders throughout the term life of the debt security. The coupons may be paid quarterly, semi-annually, or annually, and represent interest income to investors. The interest income is taxed by the government at the end of the tax year.

After a coupon is paid, the price of the bond typically decreases by the amount of the coupon. An investor that sells his or her bonds prior to coupon payment and repurchases it after payment has been made, does so to convert interest income into a capital gain, a process known as bond washing.

Investors in the high-income tax bracket are usually the utilizers of this strategy. A high-income earner may reduce or avoid his tax liability by transferring securities cum dividend to another person, say a friend or family member, who has no taxable income or falls in a low tax bracket.

Bond washing is a more effective strategy for interest-paying bonds. Its tax avoidance benefits are nonexistent for deferred interest bonds or zero-coupon bonds that pay accrued interest at maturity only.

Bond Washing and Tax Avoidance

Bond washing is a method of tax avoidance that involves selling a bond cum dividend and buying it back ex-dividend. To achieve this, a bondholder finds a buyer who is willing to purchase the bond and receives the coupon as the bondholder of record. The buyer agrees to sell the bond back to the original holder at a predetermined date after the tax period closes.

The sale price, usually the same amount as the original purchase price, is also agreed on by both parties involved in the collusion. In this manner, the original bond investor holds the bond again but avoids paying taxes on the bond coupon income. In effect, the investor generates a tax-free capital gain on his or her sale and repurchase transaction.

Some jurisdictions consider the interest to be the income of the transferor or original bondholder and will, thus, tax the investor on that income if the investor is discovered to have carried out a bond washing scheme. Fixed-income investors looking to implement this strategy should compare the benefits received from avoiding taxes on interest income to the costs that may be incurred from any fines or penalties that may come about from implementing this measure.