Why the time is ripe for tax swaps

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With municipal yields rising more than they have in years, investors should be poised to take advantage of a rare opportunity for tax swapping as the fourth quarter gets underway, municipal experts said.

Investors can use tax swapping to offset gains in their equity positions thanks to the higher-rate environment in the municipal market, according to Chris Brigati, managing director and head of municipal trading at Advisors Asset Management.

"Investors have not had as robust an opportunity in recent years due to lower yields,” he said in an interview last month. “This could create some trading opportunities as investors seek to harvest losses on paper purchased at much lower yields.”

Benchmark yields in 10 and 30 years have risen more than 50 basis points since the start of the year, according to Municipal Market Data.

Generic triple-A general obligation bonds yielded 2.58% in 10 years and 3.21% in 30 years as of Oct. 2, compared with 1.98% and 2.55%, respectively, on Jan. 2, MMD data showed.

Capital losses realized from a tax swap can be used to offset realized capital gains from other investment sales, or may create a capital loss carry-forward that can be used in subsequent years to offset income and capital gains, according to an October research report from Putnam Investments. In addition, up to $3,000 in net capital losses can be used to reduce current taxable income. Investors can also use losses from multiple funds or other securities to cancel out a larger amount of realized gains.

Tax swapping is just one of the variety of investment strategies that municipal experts are recommending in the remainder of 2018. Upgrading credit quality, using a barbell structure, avoiding high-yield and riskier investments are among the tactics to help provide value as the year comes to a close.

“Record highs in the equity markets could call for some rebalancing of portfolios resulting in taking some gains on sales of high-flying stock positions,” said Brigati, arguing that it would be "prudent" for investors to "engage in the municipal market" in the fourth quarter.

Morgan Stanley Wealth Management’s Matthew Gastall, executive director, and Monica Guerra, vice president, also suggest investors consider executing tax swaps to strengthen portfolio positioning as liquidity has recently improved.However, they urge investors to wait for the current Treasury weakness and volatility to end before doing so.

Monitoring Treasuries for leadership — indicative of a number of days of stability and firmness — helps give investors direction on putting that strategy into action,
Gastall said in an interview.

Brigati also suggests investors take advantage of market volatility by putting large sums of idle cash to work as rates have spiked.

“The opportunity cost of non-performing cash positions in prior years while waiting for a back-up in rates has been high,” he said. “Investors that had taken such an approach should look to the higher rate environment to finally get invested. We believe the market will continue to present investors with the highest yields we have seen in over seven years on the heels of rising rates in the U.S. Treasury market.”

Demand for extra yield will be another key theme in the fourth quarter as investors’ expectations have been buoyed by the weakness in Treasurys, according to John Mousseau, president and chief executive officer of Cumberland Advisors.

“We’ve seen rises in longer-term Treasury yields after three quarters of a year of mostly flattening,” he said. On Oct. 2, the 10-year Treasury yielded 3.07%, while the 30-year yielded 3.22% — slightly lower following last month’s record-setting weakness.

Treasury prices for the 10-year note yield rose above 3.10% on Sept. 25 to its highest level since May a day before the Fed raised rates 25 basis points for the third time this year at its two-day policy meeting.

The yield on the benchmark 10-year Treasury rose 3.5 basis points to 3.113% — breaking the record for the highest intraday level since May 18 and on track for its highest close since July 2011, according to Dow Jones Market Data. The 2-year yield was up 4.3 basis points to 2.843%, while the 30-year Treasury bond yield climbed 3.6 basis points to 3.247%.

With ratios of municipals to Treasurys expensive on the shorter end of the yield curve, and cheaper on the long end, Mousseau expects any additional rise in long-term yields will be more muted in municipals than in Treasurys.

The ratios of municipals to Treasurys ranged from as low as 72.5% in one year to 84.6% in 10 years and 100% in 30 years as of Oct. 2, according to Thomson Reuters data.

“We think part of that is the hangover of supply from earlier in the year and the erosion of the buying base in the longer end, between banks and insurance companies buying less,” Mousseau said.

Mousseau expects credit spreads to start to widen given the perception that the market is heading toward the end of the Fed hiking cycle, which he says should occur by yearend.

Currently, the spread between triple-A generic general obligation bonds and single-A hospital bonds is 57 and 63 basis points in 10 and 30 years, respectively;the spread for single-A housing revenue bonds is 94 basis points in 10 years and 125 basis points in 30 years, according to Municipal Market Data.

Municipal investors should pay even closer attention, according to Gastall and Guerra, to macroeconomic developments in the next three months that could “incite” U.S. Treasury weakness, such as any above-consensus economic progress, concerns of foreign ownership of U.S.Treasury debt, transitioning inflationary expectations, changes to global monetary policy, and upcoming Fed action, the pair wrote in a Sept. 19 report entitled “To Everything Turn.”

Quality is king
A solid foundation in the municipal market will help investors improve and strengthen portfolio positioning, focusing on high-quality tax-exempt and taxable securities on the front end of the yield curve to improve credit quality, according to the Morgan Stanley team.

“Tight credit spreads and a flatter yield curve suggest that the current period continues to be one of the most advantageous times in the last 10 years to upgrade quality and/or shorten final maturities,” the analysts wrote in their report.

They continue to favor a front-end, high-quality focus for household investors, particularly high-quality securities with above-market coupons, evenly distributed call options, and final maturities laddered under 11 years. They say the additional compensation for interest rate risk is approaching 10-year lows.

Triple-B credits currently yield 82 basis points of additional spread to the triple-A scale, while the long-term average BBB spread is 104 basis points from 1993 to present, while the post-2009 average is approximately 133 basis points, according to data compiled by Thomson Reuters Municipal Market Data.

Single-A-rated spreads, meanwhile, yielded 47 basis points above the triple-A scale as of last month, while the long-term average A-rated spread was 46 basis points from 1991 to present. The post-2009 average is 68 basis points.

Gastall and Guerra said investors should maintain the appropriate exposures to cash and blend high-quality taxable counterparts in the very shortest maturities, where yields have risen in U.S.Treasuries more than municipals.

Volume and Fed fever

Supply is another major concern for investors and traders, as issuance has been down about 20% year over year.

Ratios of 10-year municipals and Treasuries have recently been hovering around 85%, kept in check by Trump Administration's tax changes that have limited supply, and are likely to remain in a similar range, according to Brigati.

Tom Kozlik, managing director and municipal strategist at PNC in Philadelphia, said supply has been higher in 2018 than he expected. “I think much of that is because issuers have finally felt more stable from a financial perspective – nine years into the economic expansion.”

The direction of interest rates can also impact investment strategies as the end of the Fed’s rate hike cycle nears, Mousseau said.

His firm is using a barbell strategy, but adjusting the short end of the barbell from under three years out to the seven-to 15-year range on one end, and moving the 20- to 35-year paper “with par-ish coupons and calls” to shorter paper between 12 and 15 years, non-callable and zero paper in order to make the portfolios more convex.

Convexity is risk management tool that helps measure and manage the amount of market risk to which a bond portfolio is exposed.

"When rates have risen to the point where we think we are near a peak we want to move to structures that will not be encumbered from a performance standard by call features," Mousseau said.

“Right now, we think the long end of the muni market — because of the cheapness of the ratios — is like having a life preserver around the bonds from a price risk standpoint.”

Mousseau expects those ratios to move to lower than 100% over time — as low as 90% or 85% on high-grade, triple-A credits.

“We have not gone through a hike cycle since the 2004 to 2006 period," when ratios dropped from approximately 103% to 85% on the long end, Mousseau said. “We expect that pattern to repeat itself.”

“I think investors are basically signaling with the very expensive ratios in the short end that they are expecting a change in Congress and possibly a change in the tax code down the road," Mousseau said. "Or even perhaps a change in the White House in 2020.”

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