The fall harvest season is upon us here in the Northwest, and not just at the pumpkin patch. In the municipal market, the rising interest rate environment during 2018 has created opportunities to harvest losses in certain municipal holdings. Referred to as tax loss harvesting, the trading strategy involves selling a bond that has declined in price due to increasing interest rates, and then subsequently reinvesting into a similar bond that has also declined in price. The loss that is realized is an asset that can be used to offset gains in other parts of client portfolios.
Municipal bonds are well suited for tax loss harvesting because the wash sale rule for munis is not overly restrictive. As long as the bond purchased is slightly different from the bond that was sold, such as having a different maturity date, coupon or issuer, 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 a Dallas ISD bond with a 5% coupon that matures in 2025. Both Northeast and Dallas school districts are located in Texas, have Aa1 ratings and consistently trade in a very similar manner, which makes us indifferent to any minor differences between the two holdings.
Over the course of 2018, we have identified and executed swaps in client accounts to generate tax loss assets. The recent spike in bond yields has likely created more opportunities to harvest losses. We will be actively searching for more 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 where we have high conviction and that are not replicable based on current market opportunities.
Overall, this opportunity, if pursued properly, can add value for our clients, and we’ll be trying to maximize this value over the coming weeks.