High Yield Bonds For High Yield Munis

Why a tax-swap out of corporate into muni could make sense right now.

While many investors most often think of tax-loss swaps as a year-end strategy, now may be a good time to review your portfolio for opportunities to harvest tax losses.

This can be particularly timely for investors with allocations to high-yield corporate bonds who may be disappointed by recent negative returns and who were also surprised by the higher-than-expected correlations with their equity positions. (Of course, some investors without exposure to high-yield corporate bonds are currently thinking about getting in, suggesting that now could indeed be a good time to think about harvesting losses.)

Investors who want to reduce the equity correlation of their fixed-income allocation and are comfortable maintaining their exposure to noninvestment-grade credit risk may want to consider swapping from high-yield corporate bonds into high-yield municipal bond ETFs.

Different Risks & Performance

While the credit risks in high-yield municipal bonds can be much different from traditional investment-grade public-purpose municipal financings, the recent performance of the high-yield muni sector has been much different from high-yield corporates, as shown by the indexes below.

Source: S&P Dow Jones Indices

If you are going to consider a tax-loss swap, be sure to consult in advance with your tax advisor for guidance on how the IRS regulations will apply to your specific situation.

Because of the need to avoid a “wash sale” when doing a tax-loss swap, investors in individual securities may find it easier to use ETFs to avoid buying “substantially identical” securities.

You can use ETF.com’s ETF Screener to identify potential replacements. (By leaving the “Category” drop-down on “All Categories” and selecting “High Yield” in the Focus menu, you will get a list of ETFs that will include corporate and municipal high yield.)

There are currently three high-yield municipal bond ETFs, which are highlighted below. Also included on the list is the Market Vectors CEF Municipal Income (XMPT), which, instead of taking on noninvestment-grade credit risk, takes on the heightened interest-rate risk inherent in the underlying leveraged municipal bond closed-end funds.

Higher Risk Than Other Munis

Keep in mind, though, all of these funds have more risk than traditional municipal bond ETFs and should be expected to be more volatile. In most cases, exposure to high yield should only be for a portion of the overall fixed-income exposure.

When evaluating these as swap candidates versus existing holdings in corporate high-yield ETFs, be sure to compare the average credit quality of both funds, and also the interest-rate risk as measured by the duration. (Both of which are shown on the ETF Screener/Fundamentals tab.)

ETF data as of March 1, 2016, based on FactSet data from ETF.com

Patrick Luby is the author of www.IncomeInvestorPerspectives.com and has decades of experience in helping advisors and investors understand the municipal bond market. At the time this article was written, the author did not have any positions in the securities mentioned. This is not a recommendation to buy, sell or hold any of the securities mentioned. Luby does not provide investment, tax, legal or accounting advice. Investors should consult with their own advisor and fully understand their own situation when considering changes to their strategy, tactics or individual investments.