How tax efficient is your municipal bond portfolio?
Investors typically think of municipal bond products as being tax-free. However, in many cases, that is not the reality. Although the interest income from municipal bonds is typically tax-free at the federal level, any price gains realized on buying and selling the bonds within the product can create a tax liability. Within Morningstar’s Municipal National Intermediate universe of mutual products, the average municipal bond fund surrendered 5 basis points (0.05%) per year of performance to taxes for the 10 years ending December 2013. In a year in which tax rates increased, the average tax cost for the same universe in 2013 was almost double the 10-year average, at 9 basis points (0.09%). This may not sound like much, but in the current low interest rate environment, every basis point counts.
Tax efficient municipal bond portfolio management techniques
Only 23% of the funds in the Morningstar Municipal National Intermediate universe have not had a tax distribution in the 10 years ending 2013. How do they do it? Here are some examples of techniques they may have used.
Among other things, many savvy managers may apply tax loss harvesting techniques to help manage taxable distributions. For example, last year the broad municipal bond market experienced negative returns. While accounting for transactions costs, a portfolio manager could comb through the portfolio looking for securities to sell at a loss and replace with securities of equal diversification benefits. The losses could either be used to offset any securities that were sold at a gain that year, or tucked away as a tax loss carryforward. A hypothetical example is given below where characteristics for the two bonds are nearly identical, except for the issuer. The difference in issuer helps prevent a “wash sale.”1
The benefit of a tax loss carryforward is especially relevant when interest rates are falling (and bond prices are increasing) as we’ve seen in early 2014. This allows a manager to continue to apply an active strategy of selling expensive bonds and purchasing cheap bonds, even if a capital gain is incurred. In the absence of a tax loss carryforward, the hurdle to sell a bond with a potential capital gain is much higher, and could prevent a tax-sensitive manager from actively trading the portfolio.
Additional active management strategies
Some managers may weigh the risks of holding a relatively volatile credit like Puerto Rico versus its benefit of triple tax-exempt status as a U.S. territory.2 Managers may take active decisions regarding the purchase of municipal bonds subject to the Alternative Minimum Tax.3 Managers also generally keep an eye on excessive portfolio turnover.
Size matters when it comes to municipal bond products
But none of these tax-saving techniques would be nearly as valuable without one additional benefit of professional management: size. Municipal bond portfolio managers can benefit from scale to apply these techniques at low trading costs. Individual investors who attempt to do tax swaps in trade block sizes under a million dollars can have a hard time doing so efficiently. As the chart demonstrates, municipal bonds traded in smaller block sizes are at a significant pricing disadvantage.
1 Wash Sale: Occurs when you sell or trade stock or securities at a loss and within 30 days before or after the sale you buy substantially identical stock or securities. You cannot deduct losses from a wash sale.
2 Triple tax exempt status: exempt from federal, state, and local taxes.
3 Certain private activity municipal bonds are subject to the federal alternative minimum tax. The yield on these bonds tends to be higher to compensate for the potential risk that they become taxable to certain investors.
Bond investors should carefully consider risks such as interest rate, credit, repurchase and reverse repurchase transaction risks. Greater risk, such as increased volatility, limited liquidity, prepayment, non-payment and increased default risk, is inherent in portfolios that invest in high yield (“junk”) bonds or mortgage backed securities, especially mortgage backed securities with exposure to sub-prime mortgages. Investment in non-U.S. and emerging market securities is subject to the risk of currency fluctuations and to economic and political risks associated with such foreign countries.