How Higher Rates Can Create Assets for Municipal Investors

After the jump in rates that occurred in late 2016, Treasury bonds more or less traded sideways for much of 2017. Since touching an interim low in early September of 2017, interest rates have steadily increased as the Federal Reserve has continued the process of gradually tightening monetary policy, and as some expectation of growth stimulus from U.S. tax reforms has been priced into the market. As the below chart depicts, the largest changes have been limited to bonds inside of 15 years, as investors remain skeptical of a true acceleration in either growth or inflation.

Nonetheless, this move in the level of rates has created a particular opportunity for municipal investors.

In this case, the opportunity comes in the form of tax-loss harvesting (a subject we last wrote about and took advantage of in late 2016). Tax loss harvesting is a trade in which bonds are sold that have decreased in value to lock in the losses, and, subsequently, similar bonds are purchased so that overall portfolio exposure remains constant. 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 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 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.

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We have begun to sort through portfolio holdings and execute swaps in client accounts to generate tax loss assets. 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. 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. Overall, this opportunity, if pursued properly, can add value for our clients, and we’ll be trying to maximize this value over the next few weeks.

Sources: Bloomberg, IRS & SNW Research