Tax Time Creates Opportunity in Short-Term Munis

Tax Time Creates Opportunity in Short-Term Munis

As tax season winds down, we see some compelling reasons for U.S. investors to look at short-dated municipal bonds.

A period of technical weakness in front-end munis is typical at tax time as investors sell these positions (along with tax-exempt money market funds) to pay federal, state and local tax bills. This year is no different: Federally tax-exempt yields for the SIFMA Municipal Swap Index are at a near 10-year high of 1.75% this week as tax season selling caused supply to outweigh demand (see chart). This 1.75% tax-exempt yield equates to a 2.96% taxable equivalent yield (the pretax yield a taxable bond must possess to achieve the yield of a tax-free municipal bond) and exceeds one-year fixed-rate AAA MMD (Municipal Market Data) index yields, with less duration risk. Investors may want to take note.

We expect SIFMA Index yields, after having been suppressed for some time amid near-zero Federal Reserve policy rates, will continue to grind higher for the foreseeable future as weak technicals persist at least through mid-May and the Fed proceeds with its gradual hiking path.

Investment takeaways

How can municipal investors take advantage of potentially higher SIFMA index resets? One option is investing a portion of their portfolio in a short duration muni strategy with a significant allocation to variable rate demand obligations (VRDOs) or other floating rate notes with coupons that move in line with the index, or at a spread to it. The coupons on these instruments reset frequently (daily, weekly or monthly) and enable investors to capture SIFMA resets as well as movement in the fed funds rate.

 

U.S. readers can find more of our municipal market insights here.

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Julie Callahan and David Hammer are municipal bond portfolio managers and co-managers of the short duration muni strategies. Both are contributors to the PIMCO Blog.

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Disclosures

All investments contain risk and may lose value.  Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds for U.S. tax payers is exempt from federal tax, but may be subject to state and local taxes and at times the alternative minimum tax.

There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve results similar to those shown. Investors should consult their investment professional prior to making an investment decision. It is not possible to invest directly in an unmanaged index.