After a bruising September and early October, muni holders sold weaker bonds to book losses for taxes and then bought back exposure through ETFs. LSEG Lipper Global Fund Flows clocked $5 billion into muni ETFs in the week to Oct. 14, beating the previous weekly record of $3.3 billion set the week before. Over the same period, open-end muni mutual funds shed $3.4 billion, the largest weekly pullback since June 2022.
Trading has been intense. Municipal Market Analytics says just seven trading days in October topped the full-month trading volume seen in 93% of months from 2007 through 2021. That surge followed September, the worst month for munis since 2008.
Muni yields have jumped to levels not seen in decades, which makes stepping back in more appealing. Since interest from munis does not face federal income taxation, the category carries a unique tax benefit. Pacific Investment Management Co. put it plainly: "municipal bond investors can utilize tax-loss harvesting to potentially eliminate tax liabilities."
Managers have been promoting tax-loss harvesting across markets, but with other assets the move can simply postpone taxes. Even after the selloff, munis remain in a "very fluid and functioning market," said Wesly Pate, who is a senior portfolio manager with Income Research + Management. "It's allowing the facilitation of a lot of these harvesting trades," he said, adding, "We're still probably at the very early innings of the tax-dollar harvesting that is going to occur throughout the year."
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In Los Angeles, Capital Group fixed-income portfolio manager Mark Marinella said awareness of the tactic picked up in 2022 as the Federal Reserve raised rates and bonds weakened. He is not seeing investors abandon munis, which have rebounded over the last two weeks and show a 2% gain so far in October. He called tax-equivalent yields "really high," saying that helps explain "why you're not seeing people run away with negative returns." Many are turning to ETFs after completing harvesting trades.
The move away from mutual funds has been building for years as investors favor ETFs and separately managed accounts. Since September, the big, passively managed muni ETFs from BlackRock and Vanguard, tickered MUB and VTEB, have drawn sizable weekly inflows. According to Matt Fabian of Municipal Market Analytics, a large share of the cash exiting mutual funds is not likely to come back. "If you were planning to eventually migrate to ETFs and then a tax-loss harvesting opportunity came along, you'll probably just make the transition then," he said. Trading individual muni debt can be complex and investors usually hold to maturity, so "If they're making a decision to sell, they might as well reposition while they're at it."
The mix right now is clear: steep recent losses to harvest, federally tax-exempt income, high tax-equivalent yields, and liquid ETFs to plug back in. That recipe is pulling cash from traditional muni funds and into ETFs at a record pace.
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