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 can result in tax-free capital gains because
after the coupon has been paid, the bond will sell for less.

KEY TAKEAWAYS

Bond washing is when a bond is sold immediately prior to its coupon payment, and then
repurchased once it has been paid.

The idea is that the bond's price will be lower following an interest payment, so they can record a
capital gain while forgoing the interest income.

Bond washing is a tax-avoidance strategy and has been disallowed in several 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 that is willing to purchase the bond
and receive 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.