How muni bond ETFs can make tax-loss harvesting a smarter strategy
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As the end of the year approaches, investors start to think more about how their trades will affect their bill from the IRS next April, and that may be sparking a shift into funds that promise tax-free income. Municipal bond ETFs are seeing an influx of cash in the waning days of 2023, which could be a byproduct of tax-loss harvesting. That strategy involves selling losing investments in order to book the negative return in the current year with the aim of helping to offset taxable gains elsewhere, or up to $3,000 of ordinary income. The process can be applied to individual stocks as well as to investment funds. While bond prices and the S & P 500 have recovered sharply over the past five weeks, many investments still show paper losses for 2023 or the last couple of years. And when tax bills are at front of mind for investors, municipal bond ETFs can offer an attractive place to park the cash generated from selling losing positions. "This is the season to do it, and I think rotating into active muni ETFs can make a lot of sense, particularly for those clients in your highest income tax brackets," said Courtney Wolf, fixed income portfolio manager at Capital Group. "These tax equivalent yields [on munis] are pretty interesting." Some investors are already moving cash in that direction. The municipal bond ETF category has seen nearly $3 billion of net inflows over the past month, according to FactSet. The iShares National Muni Bond ETF (MUB) has led the way with about $988 million of net inflows. "I think if you look at [tax exempt] ETF flows in the fourth quarter, they tend to pick up. My sense is that's a result of tax loss harvesting," said Wolf, who is a manager for the Capital Group Municipal Income ETF (CGMU) . The payouts from municipal bonds are generally exempt from taxes, though the exact details differ by state and where an individual investors lives. That means that the yields listed on the funds' websites and marketing materials are lower than many other fixed income products, but the true realized income is highly competitive, especially for wealthier investors. For example, BlackRock says the MUB has a tax-equivalent yield of 5.92%, but a 30-day SEC yield of 3.50%. "The higher your tax rate, the more valuable the exemption is to that investor," said Adam Weigold, head of municipal strategies at Manulife Investment Management. Munis vs other bonds Bond prices have rallied across the board over the past six weeks, with the 10-year Treasury yield falling below 4.3%, down from 5% in late October. (Bond prices and yields move inversely to one another.) Municipal bonds are no exception, with price of the MUB rising more than 3% over the past month. MUB 1M mountain Municipal bond funds like the MUB have rallied over the past month. But that doesn't mean that municipal debt always trades in a similar pattern to corporate bonds and Treasurys. In addition to different tax treatments, there are nuances between the municipal bond market and other parts of fixed income. One key is that municipal debt carries more credit risk than federally-backed Treasurys. However, Duane McAllister, managing director at Baird, said that credit quality outlook for municipal debt is still being supported by the extra cash from Covid relief bills that many local governments still have. "We're at a point today where municipal credit is really, really strong," McAllister said. Another hot topic in the bond market is supply. Some traders are concerned that the large federal budget deficit will push up Treasury yields as the market struggles to absorb new debt. For municipal debt, however, that is not a direct concern. "We lack some of the problems that Treasurys do with over-issuance," said Manulife's Weigold. "Our issuance is actually down this year. And the credit quality in our market is very strong. I think local government credit is probably as strong as it's been, at least by the metrics, that I've seen in my 25-year career." Manulife is one of several asset managers to launch a new muni ETF recently, with its John Hancock unit debuting the John Hancock Dynamic Municipal Bond ETF (JHMU) in November. Other new entrants include Capital Group Short Duration Municipal Income ETF (CGSM) and Dimensional California Municipal Bond ETF (DFCA) . In October, Vanguard announced plans to launch two more tax-exempt bond funds.