As the muni market navigates recent volatility and surging yields, investors have started harvesting losses ahead of yearend as inflows into exchange-traded funds accelerate and bids wanteds remain elevated.
With tax-loss harvesting investors sell assets at a loss to lower taxes, usually to offset gains.
September has historically been a negative month for the muni market from a performance perspective, said Andrew Clinton, CEO and founder of Clinton Investment Management.
Technicals are "working against" the marketplace, or at least the interests of bondholders, "in the sense that you typically see larger supply during this period of time and diminished demand simply because of the reinvestment flows and maturity schedules for the year seasonally," he said.
What has changed over the last couple of years is a more proactive approach to tax-loss harvesting toward yearend, Clinton said.
Many investors go into the end of the year trying to catch up on tax-loss harvesting, even though some analysts say it is something market participants should do year-round.
The selloff over the past several weeks has created a particularly attractive opportunity to take tax losses, said David Blair, head of the Municipal Core SMA business at First Eagle Investments. However, investors expect tax-loss harvesting this time of year, particularly within SMAs, given that there are only three months until the end of the year, he said.
"Investors are thinking about 'OK, let's take advantage of this now,'" Blair said.
"So the opportunity is there, and we're getting into the fourth quarter soon, so [tax-loss harvesting] is really starting right now," he noted.
This time of year isn't the only reason for increased tax-loss harvesting.
If, for instance, April had this kind of backup, "you'd still be seeing the tax-loss harvesting that people generally try to be proactive with," Blair said.
Because of the "outsized" negative return environment, some market participants are starting to panic, exit their positions, and tax-loss sell, said Jeff Timlin, managing partner and head of municipal bond investing at Sage Advisory.
"So you get a combination of people who are exiting and maybe moving to a lower duration, or maybe even cash, and then those who still want to maintain a similar strategy, but still say, 'Why don't we take advantage of this tax-loss selling opportunity,'" he said.
Those two factors contribute to higher bids wanteds and market volatility.
At some point, yields will become so attractive that institutional and opportunistic buyers start coming in and picking off some of these opportunities. Once the negative returns stop, people start to pile back in again, Timlin said.
"While recent volatility certainly creates opportunities for tax-loss harvesting, a bond trading at a loss isn't automatically a bond worth selling," AllianceBernstein said. It recommends investors use a "calculated framework" when realizing losses, as a higher benefit makes a security more attractive to sell, all else being equal.
Additionally, investors should keep in mind the replacement opportunity, with the objective being to "increase the portfolio's expected return by harvesting a tax loss and reinvesting in a bond with a higher expected return. The bigger the increase, the more attractive it is to sell," AllianceBernstein said.
As for transaction costs, a "bond's size, credit rating and duration all affect what it costs to sell, and that cost can rise during volatile markets."
Altogether, these factors — not the headline loss — are what should drive the decision, they said.
