07/11/07
by Dakin Campbell, The Bond Buyer
At firms across the muni marketplace, institutional traders are accomplishing transactions they may not have considered just a few months ago. They’re setting up tax swaps, and finding willing participants in mutual fund and insurance clients looking to realize recent losses.
The activity comes on the heels of a Treasury market sell-off the past month that has left muni yields significantly higher than they were earlier this year. On Feb. 27, the Municipal Market Data yield for 30-year bonds stood at 3.95%. On Monday, the yield on the same bond was at 4.50%. Falling bond prices have left many active investors suffering mark-to-market losses, and eager to utilize the advantages of tax swapping.
Tax swaps establish a balance sheet loss for bonds trading below original cost, such as bonds with a 5% coupon bought at a price of 106 that are now trading at or near par. The loss is counted against capital gains income earned on other bonds, which offsets profits and reduces the tax liability of the portfolio.
“When rates go up, bonds go down; that’s just simple bond math,” said Robert MacIntosh, co-director of Eaton Vance’s municipal group, which manages roughly $18 billion in assets. “If you can add value to a portfolio by realizing losses, you’re supposed to do that.”
A tax swap strategy is relatively common in the tax-exempt market, as both institutional and retail investors look to capitalize on potential tax advantages. However, it is a technique often utilized at the end of the year, when annual taxes are finalized. This mid-year activity is a reflection of last month’s dramatic move in rates.
“Obviously a lot of factors are at work,” said Howard Manning, a vice president at Ziegler Capital Markets who focuses on trading. “But I think the trigger mechanism, as much as anything, was the sell-off in the Treasury market and the accompanying move in the [MMD triple-A yield curve].”
When swapping, investors often look to replace the bonds they sell with similarly structured bonds. If they have a bond with a 5% coupon, they’ll look to get that same coupon, or something like it, as well as meet other similar characteristics like credit quality or the size of the original issue.
“For the most part, I think people are trying to do 'like for like’,” Manning said. “They are looking to buy — at least from our perspective — something of similar structure and similar liquidity.”
Portfolio managers are not looking to radically change the makeup of their portfolios through tax swapping. They’re looking to bump their total yield however they may, and playing with the tax liabilities of their funds is one way to achieve that goal.
The Internal Revenue Service allows the practice, with the caveat that the newly purchased bonds must differ from those sold in two of three ways: by issuer, coupon, or maturity date. It’s called the “wash rule,” and if the transaction does not satisfy it, any added yield is liable to be taxed at normal rates.
As a result, sophisticated institutional investors pursue a tax swap only when they have firm ideas of which bonds they are looking to trade out of, and which bonds they are looking to acquire. And they seldom do tax swapping just to realize the losses.
“Typically what you want to do is not just a trade for the sake of realizing a loss,” MacIntosh said. “It’d be nice to somehow add value along the way, like increase call protection, moving into a credit that you like better than another one, or a different coupon that you think is more attractive.”
MacIntosh would not disclose his investment strategy but Michael Imhoff, a managing director for institutional trading and underwriting at Stifel, Nicolaus & Co., said he is seeing clients extend into longer maturities and higher coupons.
The strategy makes sense for many funds and insurance companies, though they must be wary of selling bonds at a bigger loss than they anticipate, according to Imhoff. As they sell at a discount, prices can fall quickly. Most vulnerable are bonds bought originally at a discount that are now nearing the de minimis threshold, the point at which profit earned by investing in a discounted bond is taxed as ordinary income.
It’s a situation that might make a fund manager reluctant to enter into a tax swap, and it’s a problem that trading firms can often solve by essentially making the market for the swap. “We do make the market on both sides,” Imhoff said. “We’re very conscious to make sure that a swap makes sense because as you get deeper into discount on bonds, the bid side can fade pretty far. We want to make sure the client is getting a fair price on both sides of the swap.”
As a result, and as other investors issue bid-wanted lists for their swappable bonds, many firms have seen their trading volume pick up. In many cases they have recognized the opportunity and approached their clients with a proposal, as well.
“We’ve had many customers and opportunities to do these transactions,” said Jonathan Nordstrom, managing director for underwriting, trading, and sales at Morgan Keegan & Co. “It has been noticeable, augmenting our business in a notable way ... and our sense, certainly, is that our competition is also engaged.”
Retail investors, on the other hand, have been slow to enter the market. Less vulnerable to mark-to-market losses with a longer holding horizon, they tend to respond more sluggishly to changing market dynamics.
“Retail is a little slower,” Imhoff said. “They tend to lag institutions in reacting to market opportunity.”
But if rates stay at present levels, or go higher, retail will most likely engage in these types of trades, even as more institutional investors get into the act. It’s a market dynamic apt to keep traders busy for months to come.
“It’s an opportunity the market has not provided us with an opportunity to do in a while,” Imhoff concluded. “I think people are just now getting back into the tax swap opportunity.”
© 2007 The Bond Buyer and SourceMedia Inc.
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