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Muni Bond Tax‑Loss Harvesting: Turning Underperforming Investments Into Opportunity

Heightened market volatility has created an opportunity to increase after-tax returns in muni portfolios.

We think it’s an opportune time for municipal bonds. Fundamentals remain strong. Yields and valuations are attractive. And thanks to heightened market volatility, the market is providing an opportunity to harvest losses and redeploy capital in similar muni strategies.

What’s more, high credit quality and low correlations to riskier parts of financial markets – such as high yield corporates and equities – have historically helped make munis a “safe-haven” asset class in late economic cycles.

Reinvestment rates are higher

Yields for 10-year municipal bonds rated AAA have more than doubled from six months ago and prices have fallen, creating compelling entry points. Buy-and-hold-to-maturity investors have continued to receive a reliable income stream with no realized losses, and can reinvest maturing bonds at significantly higher yields. Keep in mind that more than 95% of the total return on the Bloomberg Municipal Bond Index over the last 40 years came from income (see Figure 1).

Muni Bond Tax-Loss Harvesting: Turning Underperforming Investments Into Opportunity

Municipal bond fundamentals remain strong

Credit quality has remained robust, and strong economic growth has pushed municipal tax revenue to all-time highs. Year to date, state income tax and sales tax revenues have soared 13% and 9%, respectively, from 2021. Property taxes also appear poised to rise in 2022 on the heels of a red-hot property market that drove up prices at record rates in many metropolitan areas.

Many state and local governments retain funds from past rounds of federal relief funding that need to be obligated by December 2024 and spent by 2026. The U.S. Treasury only recently released final guidance on American Rescue Plan spending, and many municipalities had waited on this guidance before finalizing expenditures for their portions of the plan’s $350 billion of Coronavirus State and Local Fiscal Recovery Funds. We expect federal funds to continue to play a stabilizing role for the coming years across a wide range of municipal sectors, including higher education, airports, and not-for-profit health care.

Muni default rates have remained well below those of their corporate counterparts, while the current upgrade trend is strong. At the end of April, Moody’s had upgraded 89 muni bond issues this year, and downgraded just 25 – a comfortable ratio of 3.6 to 1.

Technicals have created attractive opportunities for buyers

Despite attractive fundamentals, shifting monetary policy expectations driven by persistently high inflation have resulted in a dramatic repricing across fixed income markets. This has resulted in historically high mutual fund outflows within the municipal asset class, leading to the worst year-to-date returns in municipal bonds in 40 years – providing a potentially attractive entry point for investors. Mutual fund outflows are a function of the retail-dominated market as these investors tend to sell during periods of market uncertainty. These outflow waves have been followed by vigorous inflows and sharp price rebounds (see Figure 2).

Muni Bond Tax-Loss Harvesting: Turning Underperforming Investments Into Opportunity

Consider realizing losses in taxable accounts to reduce taxes

For the first time in years, bond investors have many options to harvest losses in taxable accounts. This strategy involves selling portfolio positions at a loss and using the loss to offset – or even eliminate -- realized gains on other investments now or in future years, including capital gains distributions from mutual or exchanged-traded funds. Tax-loss harvesting keeps more assets in the portfolio for potential growth. And if realized losses exceed realized gains, they can be carried forward and a small portion used each year to offset ordinary income (see Figure 3).

Reset clients’ expectations

Performance discussions are difficult in down markets. Harvesting losses provides an opportunity to reset clients’ income expectations by redeploying capital into similar, higher-yielding vehicles. Yields on benchmark AAA rated municipals have climbed 163-171 basis points year to date (as of 30 June). For the first time since early 2020, muni bond funds have been forced to sell positions to raise cash for net redemptions. Heavy selling has resulted in attractive opportunities for buyers who are looking to opportunistically take advantage of the current outflow cycle.

Muni Bond Tax-Loss Harvesting: Turning Underperforming Investments Into Opportunity

We believe PIMCO is well-positioned to help

The municipal bond market is complex, consisting of more than 50,000 diverse issuers and more than a million CUSIPs (e.g., issues and maturities), all traded over the counter rather than on a centralized exchange. Our systematic, technology-driven process for muni bond tax-loss harvesting sorts through the fragmented opportunity set, enabling efficient bond selection, tax-consequence consideration, and execution. Further, PIMCO leverages deep market knowledge, a broad team of analysts, and an extensive dealer network to help advisors strategically harvest municipal bond losses for their clients – throughout the year.

The authors would like to thank Jakob Bowling for his extensive contributions to this article.

Learn more about the benefits of our technology-driven approach to tax-loss harvesting here.

The Author

Mark Thomas

Account Manager, Global Wealth Management

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