Why a Bond Market Selloff Can Also Be a Payoff for Municipal Investors

November was a difficult month for bond investors. Fiscal reflationary fears over a Trump presidency and a sharp increase in oil prices because of an OPEC agreement to cut production contributed to one of the worst months for bond prices in recent memory. Ten-year Treasury yields, for example, saw the biggest monthly increase since 2009. Volatility usually creates opportunity, however, and this time is no different, particularly for municipal investors. 

In this case, the opportunity comes in the form of tax-loss harvesting, or selling bonds that have decreased in value to lock in the losses, and subsequently purchasing similar bonds so that overall exposure remains constant. Municipal bonds are well suited to tax-loss harvesting as the wash sale rule for munis is not overly restrictive. As long as the bond that is purchased has either: (1) a different issuer or (2) a different coupon and/or maturity date, the wash sale rule does not apply. This means, for example, that if we hold a 5% coupon bond issued by Northeast Independent School District in Texas that matures in 2025 and is trading at a loss, we can sell the bond and replace it with either another Northeast ISD bond with a 4% coupon that matures in 2025 or a Northside ISD bond with a 5% coupon that matures in 2025. Both Northeast and Northside school districts are located in the San Antonio area, have Aa1 ratings and consistently trade in a very similar manner, which makes us indifferent to any minor differences between the two holdings. 

We will be actively searching for loss harvesting opportunities in the coming weeks as we believe the opportunity to harvest losses is one of the key value adds for a separate account manager. However, it is important to note that loss harvesting is only prudent in situations where transactions costs can be minimized and another bond with similar characteristics can be purchased at fair market value. We will likely not be harvesting losses in credits that we have high conviction in and that are not replicable based on current market opportunities. Additionally, the opportunity set of bonds available to harvest losses is limited. Bonds purchased within the last six to nine months are the most likely candidates. To summarize, this opportunity, if pursued properly, can add significant value for our clients, and we’ll be trying to maximize this value over the next few weeks. 

Source: SIFMA