A Credit-Aware Approach to Tax Loss Harvesting in Municipals

Guest post by Triet Nguyen, Vice President of Credit Data & Solutions, DPC DATA

Editor’s note: IMTC partners with DPC DATA to bring BondVALU Credit Momentum Scores directly into the IMTC platform. In this guest post, DPC DATA’s Triet Nguyen looks at what September’s municipal selloff means for SMA managers heading into yearend.

US Treasury rates rose dramatically in September, driven by more bearish sentiment regarding the inflation outlook, the fiscal deficit and the resulting Fed policy expectations. While the selloff affected all fixed income asset classes, the municipal market was a major underperformer when faced with fund liquidations and record-high bid-wanted activities.

While the selloff created significant challenges for investors, with the right portfolio analytics and credit tool, SMA managers can turn the selloff into a unique opportunity, between now and yearend, to harvest tax losses while simultaneously reassessing the credit quality of client portfolios.

A quarterly performance to forget

As reported by J.P. Morgan, “Bloomberg’s Investment Grade (IG) Tax-Exempt Index returned -4.36% in September, its worst showing since September 2008 (-4.69%). High Yield (HY) tax-exempts offered no shelter (-4.31%, the worst performance since September 2022’s -6.16%), with both IG and HY munis lagging taxable alternatives by well over 100bp (USTs -2.24%, taxable munis -3.18%, US Corps -2.72%)”.

For the entire third quarter, the S&P Muni Bond Index was down -5.57%, dragging both its YTD and one-year total return well into negative territory (-3.62% and -2.12%, respectively).

On the flip side, tax-exempt yields as of the end of Q3 reached their highest levels in at least 15 years, with many high-grade bonds in the 20 years or longer maturity range yielding over 5.00%. This is the equivalent of a taxable yield of 7.70% for an investor in the 35% tax bracket.

The “silver lining”

While all fixed income asset classes suffered losses, the sell-off in municipals was exacerbated by tax-related selling. Indeed, the September market debacle has created a compelling opportunity for SMA managers to: (1) harvest capital losses in their clients’ municipal portfolios, to potentially offset the significant gains to date in equities and (2) restructure and optimize the credit risk profile of client portfolios while locking in the highest tax-exempt yields in decades.

Note: Tax loss harvesting strategies are subject to applicable tax rules and individual investor circumstances. Investors should consult their tax advisors regarding specific transactions.

The need for a credit tool

To accomplish both objectives, an SMA manager would need a credit screening tool that allows him or her to quickly and efficiently comb through all their clients’ holdings for potential sell candidates and, eventually, for new purchases at more attractive yield levels.

While the traditional approach would be to rely on agency ratings as your credit yardstick, most market participants do realize that a rating may be a stale indicator, as rating agencies need to go through a lengthy credit committee review process before they can assign or update a rating. This could result in a significant lag (we’re talking weeks, if not months) between the receipt of the latest financials and the actual rating action, if any.

Furthermore, not all bond issuers are rated by the rating agencies. SMA portfolios may contain smaller or infrequent issuers that lack traditional rating-agency coverage.

Introducing BondVALU Credit Momentum Scores

DPC DATA’s BondVALU Credit Momentum Scores (CMS) were created to provide users with a quick and efficient way to identify bond holdings that are trending “Weaker”, “Stable” or “Stronger”. While the CMS are not meant to be comprehensive credit ratings, as ratings often incorporate non-financial factors, they can be viewed as a fully automated credit triage system to assist research analysts, traders and portfolio managers alike.

Coverage

The CMS scoring models are sector-specific, designed to capture all the credit nuances among various sectors and are driven by DPC DATA’s MuniCREDIT database of about 30,000 obligors, with no size or rating cutoff.

Timeliness

Most importantly, the scores are updated daily to reflect the most recent publicly available financial disclosures from any municipal issuer. This can provide users with a significant time advantage over market participants who can only react to published rating changes.

Obligor-level intelligence

Last but not least, the CMS scores apply to the actual obligor(s) for any municipal issue, not to the issuer, unless they are one and the same. This addresses one of the most vexing problems in municipals, where so-called “conduit issuers” routinely issue bonds on behalf of the real “obligors,” the entities who are actually responsible for repaying the debt. By correctly identifying the obligor(s) for every bond issue, we know we’re scoring the actual credit, not a conduit issuer.

Accessing BondVALU CMS Scores on the IMTC Platform

Tax-loss harvesting decisions extend beyond credit. Managers must also consider cost basis, portfolio constraints, relative value and executable market levels. By incorporating BondVALU Credit Momentum Scores into the IMTC environment, managers can bring credit momentum into the same portfolio-analysis process used to evaluate potential tax-loss harvesting opportunities.

The result is a more integrated approach: identify potential loss-harvesting candidates, assess whether their underlying credit trends are strengthening or weakening, and evaluate potential replacement securities within the broader portfolio context.

Automating the tax loss harvesting workflow

For most fixed income managers, tax loss harvesting has been a once-a-year scramble. Screening hundreds of client accounts for losses and sourcing the right replacements takes days of manual work, so it gets pushed to yearend. Opportunities that appear in March or August simply go uncaptured, and September’s selloff didn’t wait for December either.

On the IMTC platform, harvesting can be considered every day, with every trade, at each manager’s discretion. Pre-configured workflows run daily or on each manager’s schedule, powered by IMTC’s proprietary optimization engine. The engine weighs strategy-level rules, client customizations, tax lots and available inventory to propose buys and sells across eligible portfolios, and layered on top is an independent credit overlay from BondVALU.

That inventory comes through IMTC Live Markets, which connects directly to the ECNs and dealers a firm already works with, so proposed replacements reflect live offers available in the market. Managers review the proposed trades and promote the ones they want to the Blotter. Because the IMTC optimization engine is algorithmic rather than AI-driven, the same inputs always produce the same results, and every trade comes with a clear audit trail.

Learn more about IMTC’s portfolio management solutions.

Conclusion

Periods of market volatility are never pleasant to experience, but they can create opportunities for SMA managers to implement tax-efficient and credit-aware strategies for their clients, particularly during the current tax year. By combining IMTC’s portfolio analytics with DPC DATA’s BondVALU Credit Momentum Scores, managers can bring tax considerations, relative value and changing credit fundamentals into a more integrated decision-making process.

For more details:

• IMTC: request a demo or reach out to sales@imtc.com
• DPC DATA: reach out to sales@dpcdata.com
  
  

About the author

Triet Nguyen is DPC DATA’s Vice President of Credit Data & Solutions. He has over four decades of experience in municipal research, trading, portfolio management and financial technology. In his role, Triet taps into his credit expertise to help design and execute innovative data and analytics solutions for all municipal market participants, both on the sell side and buy side.

About DPC DATA

DPC DATA provides municipal bond disclosure, obligor, and compliance data built to support research, trading, surveillance, and regulatory workflows. For more than 30 years, the company has helped market participants work with municipal data that is structured, mapped, and ready to use. For more information visit dpcdata.com.

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