Two Strategies for Today’s Municipal Market

Here are two portfolio strategies we find attractive in today’s municipal market:

  • Tax loss swaps
  • Discount bonds[1] trading at relatively attractive yields

Tax Loss Swaps

Selling bonds is an infrequent exercise for most income-oriented investors. However, when bond losses present themselves on paper, it may make sense to capture them. Losses have arisen due to the significant increase in yields (leading to lower prices) over the past two years. Investors can use up to $3,000 in tax losses to offset regular income and use losses beyond this to offset capital gains. Losses can be carried forward, as well. Additionally, a tax loss swap may offer a benefit beyond tax considerations by allowing investors to buy higher cash flowing and longer maturity securities.

Do you have current or projected capital gains? If so, we recommend investors reach out to their Investment Specialist to inquire about tax loss swaps and our bond sale process. Our process is transparent, efficient, and enables broad market exposure to increase the number of potential bidders on the securities for sale. Selling bonds in today’s secondary market requires a high amount of patience and careful consideration of bid results.

 

Attractive Discount Bonds

Discount bonds – bonds trading under par ($100) – are readily available in today’s secondary market. A discount price is a consequence of a bond’s market yield trading higher than the coupon rate it was issued at. The coupon rate is a fixed level throughout the life of the bond.

To give a simplistic example of this relationship, if a bond was issued in 2021 with a 2% coupon at par ($100) that means it had a yield of 2% to maturity. However, today that bond is trading at a higher yield (more than 2%) regardless of its maturity – as our benchmark yields for 1, 5, 10, 30-year bonds are all over 2%.

Therefore, if you were to buy this bond from a seller, you would demand a price under par as your demanded return (above 3%) is a combination of the coupon (2%) plus discount (appreciation you capture when the bond matures at par).

Low rates during COVID provided many 2.00-3.50% coupon bonds which now trade under par, at a discount. This vintage of bonds is generally avoided by the market for three reasons:

  1. Lower coupon bonds have lower cash flows and, therefore, a higher duration. This structure leads to a security that can demonstrate higher volatility, which many buyers aim to avoid during portfolio construction.
  2. The discount is taxed at one’s income tax rate or the capital gains tax rate if it falls within the de minimus threshold[2]
  3. Due to #2, municipal bonds demonstrate a higher level of negative convexity[3] due to tax ramifications on discount prices. Furthering the avoidance of many buyers for discount bonds.

The features of discount bonds noted above leads them to trade relatively cheap (higher yield) than “fuller” (4-6%) coupon bonds. And in many ways, the attractiveness of tax loss sales has led to a hefty supply of discount bonds, without significant demand for the structure.

This all results in higher than average yields to buyers and we believe an attractive structure to take advantage of for a portion of your municipal portfolio. For investors that file at a 35% (one notch below the top, 37%) or lower tax bracket, this structure becomes even more attractive.

Don’t hesitate to reach out to your Investment Specialist or Portfolio Manager to inquire about tax loss swaps or discount bonds. We hope everyone had a wonderful Thanksgiving and the holiday season if off to a great start!

 

Sincerely,

Matt Bernardi
Senior Vice President, Investment Specialist

[1] A discount bond is a security trading below par ($100)

[2] The allowable market discount under the de minimis rule is 0.250 per year. If a market discount amounts to less than 0.25 per year, the investor is required to pay the applicable capital gains rate on the accrued discount.

[3] Negative convexity is when a bond’s duration increases as yield increases. This means that as rates increase the loss in value on the bond will increase at a greater pace than the potential increase should rates have fallen. Essentially bonds with negative convexity have greater potential downside than upside as it pertains to on paper performance.