Tax-Busting Trades Fuel Rush for Muni ETFs After Fall Selloff

(Bloomberg) -- Owners of municipal bonds usually aren't happy to see their holdings go into the red, but this year, they're taking full advantage of negative returns in September and early October.

Bondholders are selling their weakened securities en masse, employing a popular strategy where the losses help to whittle down their tax bills. Then, they're using muni exchange-traded funds to get back into a market where yields are at their highest levels in decades.

For the week ending Oct. 14, data from LSEG Lipper Global Fund Flows showed investors pushed an unprecedented $5 billion into muni ETFs, crushing a record $3.3 billion of inflows set the previous week. Meanwhile, open-ended muni mutual funds lost $3.4 billion, the largest weekly outflow since June 2022.

Money managers have been touting their tax-loss harvesting strategies across asset classes, but muni bonds offer a unique opportunity for because the income is exempt from federal income taxes.

Using the tactic with some other asset classes simply defers tax payments, but "municipal bond investors can utilize tax-loss harvesting to potentially eliminate tax liabilities," according to Pacific Investment Management Co., the massive California-based bond buyer.

That's why investors have flooded the market following a September that was the worst month for muni bonds since 2008. Just seven days of trading in October exceeded the volume of 93% of full months between 2007 and 2021, according to Municipal Market Analytics, an independent research firm.

Despite the recent selloff, munis are still in a "very fluid and functioning market," according to Wesly Pate, a senior portfolio manager at Income Research + Management.

"It's allowing the facilitation of a lot of these harvesting trades," he said. "We're still probably at the very early innings of the tax-dollar harvesting that is going to occur throughout the year."

Awareness of the strategy increased in 2022, when bonds weakened as the Federal Reserve raised interest rates. That downturn helped investors realize the tax benefits that served as a silver lining, said Mark Marinella, a fixed-income portfolio manager at Capital Group in Los Angeles. He's not seeing investors give up on munis, which have started to recover in the past two weeks and are up 2% so far in October.