One of the biggest investing truths is, “It’s not what you earn, it’s what you keep.” To that end, managing taxes has become a key part of portfolio construction. Integral to that has been the concept of tax-loss harvesting. With zero-cost commissions and easily substitutable investments, it’s now easy to sell poor performing investments and use the losses to counteract gains on strong ones. But much of that has been on the equity side of the equation.
Investors shouldn’t ignore the benefits of tax-loss harvesting on the fixed-income side either.
Thanks to the shift in rates and rising inflation, investors may have a once-in-a-lifetime opportunity to gain some significant tax benefits in their bond portfolios. And with rates still rising, there’s plenty of ability to keep the tax-loss harvesting party going with bonds.
Don’t forget to check our Fixed Income Channel to learn more about generating income in the current market conditions.
A Quick Tax-Loss Harvesting Primer
It turns out pruning your portfolio can be as effective as pruning a rose bush. Removing dead or dying branches from a rose can strengthen the overall plant. Similarly, removing losing positions in a portfolio can let winners run and recycle capital. And that’s what tax-loss harvesting does.
Tax-loss harvesting involves selling those stocks, funds or assets that are currently showing a ‘paper’ loss in your portfolio. That may be difficult to do psychologically, but it makes a lot of sense overall. For example, if you own shares of a former high-flier like Shopify (SHOP) and you are down around $1,000 on the position, you could sell the stock.
The benefit is that those losses can be used to offset booked gains in other positions. Even better is that if your capital losses exceed the gains or if you have no capital gains in a year, $3,000 worth of those losses can be used to reduce your ordinary income. And if you lose more than $3,000 on a stock, the excess can be pushed into the future to offset capital gains and ordinary income later on.
Thanks to zero cost commissions, new rules requiring brokerages to keep track of gains/losses, automated harvesting programs, and the ability to sell a single stock and buy an ETF that tracks the same sector immediately after, tax-loss harvesting has become a great way for investors to generate alpha in their portfolios.
Big Bond Losses
Much of the tax-loss harvesting party and focus has been on the equities side of the portfolio. And that’s easy to understand. Bonds are pretty boring by nature and equities can have plenty of volatility behind them. However, bonds have also been acting very wildly of late.
Thanks to the surge in inflation, the Federal Reserve (Fed) has started to ratchet up interest rates. Back in June, the central bank increased rates by a whopping 0.75%. This was the biggest jump since 1994 and follows a 0.25% increase in March and a 0.50% rise conducted in May.
The problem is bonds and interest rates have an inverse correlation with each other. So, when rates rise, bond prices fall. That’s because newly issued bonds of the same credit quality and maturity will come to market having higher interest rates. This is just what has happened as the Fed has tried to curtail inflation.
According to investment manager State Street, more than 92% of fixed income ETFs are trading at a loss for the year. Those losses are pretty steep as well. Roughly 77% of all bond ETFs are down more than 4% from their one-year highs, while just over half are down by 6%. Long-dated government bonds have performed the worst, dropping by more than 9% this year. The longer a bond’s maturity, the more sensitive it is to changes in interest rate policy. All in all, State Street estimates that across all timeframes, roughly $1.2 trillion worth of fixed-income assets are now sitting at paper losses.
For investors, this is a particularly interesting environment for tax-loss harvesting on the fixed income side. This is unprecedented given the size and sheer number of bonds trading at losses.
Don’t Forget Fixed Income
To get the most out of the rise in interest rates and use bonds as ballast, getting into shorter duration bonds is the key. Not surprisingly, short- and ultra-short-term bonds have fared quite well in the current storm as their portfolios of bonds are able to roll-over quickly to new issues with higher rates. With that, selling losing long-dated bonds and funds, while buying shorter-dated ones makes a ton of sense in this environment.
Additionally, investors may consider a ‘harvest & swap’ transaction. If they own an individual bond that’s now trading at a loss, they could sell it and then buy an ETF covering the same sector. For example, if you own a bond from Coca-Cola (KO), which is still investment grade/of good quality, it happens to be at a paper loss. You could sell it, book the losses for tax purposes, and immediately buy a vehicle like the iShares 5-10 Year Investment Grade Corporate Bond ETF (IGIB), which includes KO’s bonds as well as similar investment-grade bonds. Investors get the tax benefits, a reset cost basis, and ability to stay invested in a similar asset.
Even better is the recent losses in equity positions, which may have some investors looking to sell long-term winners—particularly in the tech sector—to lock in gains. Pairing losses on fixed income investments with the gains of these long-term positions can be a powerful tax win this year.
Be sure to check our Portfolio Management Channel to learn more about different portfolio rebalancing strategies.
The Bottom Line
With so much of the fixed income world now sitting at losses, there are plenty of opportunities for investors to make the most out of tax-loss harvesting. Whether that’s selling bonds and moving to cash, swapping for a similar bond type or trading down to a lower duration, the recent moves to raise rates has provided the ability to win on the tax front. Investors should take it.
Make sure to visit our News section to catch up with the latest news about income investing.
