Tax season brings muni underperformance, short-end selling


With tax season in full swing, the muni market is underperforming and facing selling pressure as investors move out of short-term paper to pay tax blls. However, these dynamics have not made the asset class an undesirable option for investors and most expect demand to remain strong.

Munis are returning negative 0.06% month-to-date, while USTs are seeing gains 0.63% and corporates are up 1.18%, according to Bloomberg data. The one-year index is at negative 0.04% so far in March and positive 0.08% in 2024.

“Munis usually underperform this time of year,” said Steve McLaughlin, co-head of the municipal capital markets group at S&P Global Market Intelligence.

Part of that underperformance has to do with the anticipated selling tied to April 15 to cover new tax liabilities, said Jeff Lipton, managing director of credit research at Oppenheimer Inc.

There was a lot of tax loss harvesting at the end of last year, where market participants looked to “lock in any type of gains visa vie the equity markets,” Lipton said.

However, if market participants were not as effective in offsetting capital gains with capital losses, then tax bills may be “substantial” due to the success of the equity market, said Jeff Timlin, a managing partner at Sage Advisory.

This will likely create even more pronounced tax liabilities and lead to greater selling pressure in the muni market, Lipton said.

Any pressure regarding this tax season-induced selling will be “transitory,” he said. “The underlying demand profile for munis that has been in place for quite some time now is not going to suddenly disappear because of April 15.”

During tax season, munis usually cheapen as investors tend to sell their munis first, as spreads widen and yields move higher, said Eve Lando, a portfolio manager and managing director at Thornburg Investment Management.

This can especially be seen during the front end of the curve, where more of the selling during tax season happens, said Wesly Pate, senior portfolio manager at Income Research + Management,

“Investors that are holding assets with the anticipation of making tax payments are usually holding very short duration or [variable-rate demand notes],” he said.

Municipal Securities Rulemaking Board flows for one-year and in paper have increased from prior weekly averages, indicating market participants are “utilizing their municipal front-end paper to find for tax liabilities that are coming due,” Timlin said.

Maturities for one year or less represent 14% of the total par amount traded week-to-date, up from the low of 6% for the weeks Feb. 21 through Feb. 23 and Feb. 26 through March 1. This figure is also up from 10% during the first week of the year, according to MSRB data.

“Short-duration investors approach tax season with some trepidation given that funding pressures can cause significant market volatility,” said Vikram Rai, head of municipal strategy at Wells Fargo.

And, since shorter-duration fund categories have seen outflows in the past around tax season, he said “money fund managers prepare by building up liquidity.”

For the past several weeks, short-term mutual funds have seen small outflows, according to LSEG Lipper. Short-term funds saw $70 million of outflows for the week ending March 20 after $52 million of outflows the week prior.

In the past, as the calendar rolled over, the following months would see a lot of bids-wanted activity, Pate said.

“High net worth individuals would come and say, ‘We want no duration, or very limited duration, but we want a little bit of carry for the next three and a half months to get us to mid-April. What can what can be done?'”

Many investors would use VRDNs, and this demand has returned, Pate said.

“As we enter the countdown and when payments are due it shows up in daily and weekly VRDN demand,” he said.

“In the midst of tax season, the expected money-fund redemptions are pressuring floating-rate yields — daily resets finished near 4.00% and weeklies around 3.75%,” noted Kim Olsan, senior vice president at FHN Financial. “Those aberrations can spill into the 1-year fixed maturity range but aren’t expected to last long as high-quality/specialty state names capture wider spreads.”

Historically, Rai noted, there has been a seasonal increase in SIFMA resets as tax season approaches.

SIFMA will likely increase until the end of April, he said, though “the increase will be tempered despite past evidence of significant fluctuation in SIFMA resets owing to the fragile supply-demand balance for this section of the market.”

Historically, “when tax-exempt money market funds witness outflows before Tax Day, SIFMA tends to cheapen and once flows turn after Tax Day, it richens back up,” he said.

Tax-exempt money market funds usually see outflows around tax season as “investors tend to sell their near cash alternatives to pay their tax bill and SIFMA tends to reset higher around this period,” Rai said.

Despite tax season selling, market participants expected there to be less volatility this year surrounding tax season, market participants say.

The effect of tax season on the muni market will not be as “pronounced” this year, in part, due to healthy supply that can be absorbed by the market, Lando said.

The deals coming to market tend to be oversubscribed regardless of the credit, rating or deal structure, she said.

“There’s a buyer for anything and everything,” Lando noted.

“The unique dynamic that is influencing conventional tax season effects this year remains the ongoing structural mismatch between new-issue supply and strong investor demand that has kept yield volatility well contained,” Timlin said.

For the next couple of weeks the “focus will be on the very front end, and then afterward an expansion beyond the curve,” Pate said.

Investors will work with advisors to find a tax haven, with the “classic example” being munis, Pate said. Therefore, there may be “reinvigorated interest” across the curve following tax payments.

“Every year has its own distinct storyline: where rates are, richness to Treasuries, and credit outlooks,” McLaughlin said.

The recent inflows into muni mutual funds and strong separately managed account demand for the structures market participants need, “makes this a good historical entry point for new buyers,” he said.

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