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Identifying, analyzing, and taking advantage of opportunities are hallmarks of active professional portfolio management. Occasionally, market dislocations may create some easily recognizable opportunities. A case in point is the recent sell-off in the municipal market, which may have created an attractive entry point for some well-positioned buyers. But it may be time to take a look at the other side of the trade. Current holders of muni securities may view the recent price declines as a tax-loss selling opportunity. This may offer an important and much broader application to municipal investors to add aftertax value without increasing or decreasing investment exposure.
Selling a bond before it matures can create a profit or loss, resulting in a taxable event, even if it is a municipal bond. Long-term capital gains, which require a 12-month holding period, are now taxed at a maximum rate of 20%, with short-term gains taxed at a maximum rate of 39.6%. Gains also may be subject to an additional Unearned Income Medicare Contribution Tax of 3.8%. Similarly, capital losses can provide tax credits to reduce capital gains realized elsewhere. This can be especially valuable in a year where capital gains in the stock market could benefit from an offsetting loss in municipals.
Most investors consider tax-loss selling at year-end, a particularly inopportune time for the municipal market. Municipal market liquidity, historically, deteriorates markedly in November and December as traders seek to avoid adding inventory at year-end, new bond issuance is at a minimum, and many investors are trying to pursue the same tax-selling strategy. Furthermore, there is no assurance that losses in muni securities will be available for offset at the time, especially if markets recover from current levels.
That's why the current market may provide the best window for a tax-loss trade. Heavy investor selling of municipal bonds this year, from late May through July, has pressured prices lower, creating opportunities that did not exist earlier in the year. (See Chart 1.) Anxiety over the prospect of the Federal Reserve "tapering" the level of monetary accommodation, and the consequent fear of further interest rate increases, fueled near panic selling in the retail-dominated municipal market beginning in May. The relative attractiveness of the equity market provided stark contrast to recent municipal market performance in late June and early July, promoting further selling of municipal securities.
The Barclays Municipal Bond Index, January 1, 2013-July 30, 2013
Source: Barclays Capital.
For illustrative purposes only and does not reflect the performance of any Lord Abbett mutual fund or any particular investment. Past performance is no guarantee of future results.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Sales of municipal bond exchange-traded funds (ETFs) also contributed to market pressures. In fact, sales of these ETFs were enough to force one of the market's largest ETF sponsors to temporarily stop redeeming shares for cash, offering instead to accept "in kind" redemptions from broker/dealers.1
Sales of municipal bonds continued in late July as investors reacted to Detroit's filing for bankruptcy protection on July 18. Although the announcement was widely anticipated and somewhat unique in the city's long, predictable fiscal demise, it nonetheless further affected municipal bond prices as investors pulled out funds from U.S. municipal bond funds for a ninth consecutive week.
It is unclear what will reverse the market downtrend. However, investor selling has created relative value. According to data from Thomson Reuters, as of July 25, 2013, the yield on 10-year municipal bonds (as represented by the Thomson Municipal Market Data Index), for example, was nearly 112% of the yield on 10-year Treasury notes, compared with an average of about 94% over the last four years. Barclays reported that municipal yields (as represented by the Barclays Municipal Bond Index), as of July 25, 2013, were close to 97% of corporate yields (as represented by the Barclays U.S. Corporate Investment Grade Index), compared with a 15-year average of less than 74%. And JP Morgan research reveals that long-dated 'A' and 'AA' rated tax-exempt bonds are at their cheapest levels in terms of yield spread versus corporate bonds since JPMorgan began recording such data in 2000.2 Certain tax-exempt bonds actually trade at higher yields than corporate bonds of similar quality and maturity. Such pricing should attract investor interest, potentially pushing municipal bond prices higher.
Of course, there can be no assurance that prices will improve from current levels. But investors may come to consider the May through July municipal market sell-off an overreaction to Fed policy anxiety, fear of higher interest rates, and concerns about a spillover effect from Detroit's bankruptcy filing. If that's the case, and the muni market recovers somewhat, municipal bond losses could be less by year-end, especially if new buyers are attracted to the market. More important, even if losses don't abate, the liquidity available in late summer or early fall should offer a much more attractive environment to execute tax-loss selling than the crowded illiquid conditions that could once again characterize the municipal market in November and December. As with much in life, timing is everything.
A Note about Risk: Investing involves risk, including the possible loss of principal. The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Bonds may also be subject to call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. The income derived from municipal bonds may be subject to the alternative minimum tax. Federal, state, and local taxes may apply. There is a risk that a bond issued as tax-exempt may be reclassified by the IRS as taxable, creating taxable rather than tax-free income. The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. No investing strategy can overcome all market volatility or guarantee future results.
Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.
Yield is the annual interest received from a bond and is typically expressed as a percentage of the bond's market price.
Lord Abbett does not offer exchange traded funds (ETFs) or index funds. An ETF is a security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stock on an exchange. ETFs experience price changes throughout the day as they are bought and sold. ETF products, like all investments, are subject to market risk, which may result in loss of principal. Bond ETF products are subject to interest rate, credit, and inflation risk.
A long-term capital gain is the profit you realize when you sell a capital asset that you have owned for more than a year at a higher price than you paid to buy it. If you hold the asset for less than a year, you have a short-term capital gain. A long-term capital loss is the loss you realize when you sell a capital asset that you have owned for more than a year at a lower price than you paid to buy it. If you hold the asset for less than a year, you have a short-term capital loss.
Tax-loss selling (also known as "harvesting") describes the process of selling certain securities at a loss to offset the taxable gains from other investments. Many investors use this technique to reduce their tax bill. The difference between short- and long-term capital gains plays a key role in developing a loss-harvesting strategy, since you must use short-term losses to offset short-term gains and long-term losses to offset long-term gains. At the end of the tax year, when many investors are selling off securities for tax purposes, tax-loss harvesting may affect the price of certain securities and may even noticeably impact the market as a whole.
The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year. To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, Standard & Poor's, Fitch. If only two of the three agencies rate the security, the lower rating is used to determine index eligibility. If only one of the three agencies rates a security, the rating must be investment-grade. Bonds must have an outstanding par value of at least $7 million and be issued as part of a transaction of at least $75 million. The bonds must be fixed rate, have a dated-date after December 31, 1990, and must be at least one year from their maturity date.
The Barclays U.S. Corporate Investment Grade Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate, taxable corporate bond market. It includes U.S. dollar-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers that meet specified maturity, liquidity, and quality requirements.
The Thomson Municipal Market Data Index tracks municipal bonds with the highest investment-grade rating (AAA/Aaa) from Standard & Poor's, Moody's, or Fitch, and is often used as a reference for pricing new bonds from around the country or for evaluating bonds already on the market.
The credit quality ratings of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor's, Moody's, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.
Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
The opinions in the preceding commentary are as of the date of publication and subject to change based on subsequent developments and may not reflect the views of the firm as a whole. This material is being provided for educational and informational purposes only and is not intended to be legal or tax advice and is not to be relied upon as a forecast, or research or investment advice regarding a particular investment or the markets in general. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy or completeness of the information. Investors should consult with their appropriate tax, legal, and financial advisors with respect to individual circumstances and all applicable federal, state, and local tax laws.