Buying municipal bonds usually helps individuals lower taxes. This year, amid the worst losses in the $3.7 trillion market since 2008, so does selling the debt.
While the Standard & Poor’s 500 index of stocks has risen about 24 percent this year, city and state securities have dropped 2.5 percent, S&P data show. It would be the first time since 1999 that the equities gauge has climbed while munis fell. Investors looking to minimize 2013 federal capital-gains taxes can sell local debt or muni mutual funds and take a loss to offset equity profits.
The higher tax rates Congress passed this year have some top earners seeking ways to lower costs. That could spur further muni losses in the final weeks of 2013 as selling converges with the typical year-end trading lull, said Chris Ryon at Thornburg Investment Management. The market has gained from Nov. 1 through year-end in 10 of the past 14 years, S&P data show.
The market may “get a big flood of money out of municipal-bond mutual funds, which could add to volatility at the end of the year,” said Ryon, who helps oversee $10 billion of munis from Santa Fe, New Mexico. “The question is if they go back into the mutual funds right away, or if they sit on the sidelines for a while.”
The top tax rate on long-term capital gains and dividends rose to 20 percent from 15 percent on Jan. 1, and President Barack Obama’s health-care law added an extra 3.8 percent levy on such income for high earners. Investors looking to reduce the payments while also maintaining municipal-bond holdings can execute what is known as a tax swap. That involves selling debt for a loss and purchasing what the Internal Revenue Service deems a substantially different security.
Most municipal-debt interest is exempt from federal, state and local levies and even the Affordable Care Act surtax, which makes it attractive for higher earners. Holders still pay capital gains on any price appreciation if they sell the bonds.
Congress set the top tax rate for income above $450,000 for married couples or $400,000 for individuals, after deductions. Those are the same thresholds for the top levy on long-term capital gains and dividends.
Individual investors own about 70 percent of local-government bonds either directly or through mutual funds, Federal Reserve data show.
Investors who hold Puerto Rico bonds or one of the 77 percent of muni mutual funds that own the commonwealth’s debt may face the biggest losses. The island’s securities have declined 15.6 percent this year, S&P data show.
Another round of selling would add to a record exodus from muni mutual funds. Individuals have already pulled about $48 billion from the portfolios in the first 10 months of the year, a reversal from the $44 billion inflow over the same period in 2012, Lipper US Fund Flows data show.
Tax-exempt debt has still gained in back-to-back months for the first time since February as Federal Reserve Chairman Ben S. Bernanke refrains from reducing the central bank’s bond-buying program. Benchmark yields, which move inversely to prices, set a four-month low on Oct. 31.
Because of the rally, now may be the best time for a tax swap rather than waiting for the year-end deadline, Vikram Rai, a fixed-income strategist at Citigroup Inc. in New York, said in an interview.
The difference between what buyers are willing to pay and what sellers demand “will be wider in December because of low liquidity,” he said. “It could add to weakness in the market.”
Trading tends to decline in November and December, which include market holidays for Thanksgiving and Christmas.
In 2012, institutional bondholders such as mutual funds put an average of about $1 billion of munis up for sale each day in the week through Dec. 21, data compiled by Bloomberg show. The following week, which included Christmas, the average sank to $258 million.
“Clients who give their bond portfolio manager plenty of notice tend to benefit from more efficient execution of tax-loss swaps,” said Justin Land, who helps manage $3 billion of munis at Wasmer Schroeder & Co. in Naples, Florida. He said he’s been looking at opportunities for such a move since July because “December could get messy.”
Investors whose capital losses exceed gains can also deduct the declines against ordinary income by as much as $3,000 and carry any unused portion forward to offset future returns, Phil Fischer, head of muni research at Bank of America Merrill Lynch, said in a report.
The IRS’s wash-sale rule prohibits individuals from recognizing a loss when selling a security if they purchase the same one within 30 days. Investors can work around that restriction if they switch within the same locality, such as trading Charlotte, North Carolina, water-revenue bonds for the city’s general obligations, Land said. Both have AAA ratings from S&P.
Swapping will help balance buyers and sellers in the final months of the year, rather than the period being skewed toward investors looking to offload munis, said John Bonnell, who helps oversee $20 billion of local debt at USAA Investment Management Co. in San Antonio.
“December is going to be pretty noisy and pretty busy this year,” said George Friedlander, Citigroup’s chief muni strategist in New York. “The losses are there, and people want to take some gains on the equity side.”
Issuers nationwide are offering about $5.3 billion in long-term debt this week with benchmark yields at the highest since Oct. 22.
Top-rated 10-year munis yield 2.76 percent, compared with 2.77 percent on similar-maturity Treasurys.
The ratio of the interest rates, a measure of relative value, is about 99.6 percent. It fell below 100 percent on Nov. 8 for the first time since June. The smaller the number, the more expensive munis are compared with federal securities.
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