Can you turn an unrealized loss into an opportunity?

That’s what many municipal bond investors are doing after getting an unwelcome surprise from their recent account statements.

Municipal bond prices fell sharply in September. As Goldman Sachs noted, persistent inflation concerns, the Federal Reserve’s interest rate hike – its first in three years – and renewed tensions in the Middle East all contributed to the decline.

But rather than simply riding out the decline, many investors are taking advantage of a potentially valuable opportunity: Tax-loss harvesting. And with lower bond prices translating into higher yields, there is added incentive to reinvest.

Expected fluctuations

It’s not unusual for the market value of municipal bonds to fluctuate. Sometimes long-term bonds will be worth more than when they were purchased, sometimes less.

But sophisticated investors are primarily interested in tax-exempt income, so those price changes are less important than they appear. After all, investors buy munis for their uninterrupted stream of tax-exempt income, not capital appreciation. They usually hold their bonds until they mature or are called, and the interest payments on existing bonds remain unchanged, regardless of daily price changes.

And according to Nuveen, the recent selloff was driven by interest-rate pressures, not deteriorating municipal credit quality. Invesco also reports that municipal credit fundamentals remain resilient, with rating upgrades outpacing downgrades.

Still, there is opportunity in those gyrations.

In fact, the recent selloff has prompted a surge in tax-loss harvesting, according to Bloomberg. Investors poured a record $5 billion into municipal exchange-traded funds during the week of Oct. 14, largely reflecting efforts to realize losses while maintaining exposure to the municipal market.

Turning losses into savings

Tax-loss harvesting involves selling an investment that has declined in value to realize a capital loss, which can be used to offset taxable capital gains elsewhere in an investor’s portfolio.

For municipal bond investors, the strategy can be particularly appealing because it doesn’t mean interrupting their flow of tax-exempt income.

One way to accomplish this is through a municipal bond tax swap. That is, selling a bond at a loss and simultaneously reinvesting the proceeds in another suitable municipal bond. The replacement bond should offer a different maturity, coupon or credit profile.

There are important considerations. IRS wash-sale rules generally disallow an immediate loss deduction if substantially identical securities are purchased within 30 days before or after the sale.

Of course, consult your tax adviser to determine whether the strategy makes sense in your circumstances.

Time for a portfolio review

A carefully structured tax swap could reduce taxes while preserving tax-exempt income. At the same time, current market conditions offer opportunities to purchase quality municipal bonds at compelling yields.

Now is a good time for a portfolio review. An experienced municipal bond professional can help identify potential tax swaps and promising reinvestment opportunities.