Stock investors are often acquainted with tax-loss harvesting, which can be a silver lining when equity markets are down. However, given the steep drops in fixed income prices this year, we believe fixed income investors should consider tax-loss harvesting, as well, and consider using it as an opportunity to position their portfolios going forward.
That said, there are some differences between tax-loss harvesting in fixed income compared with equities, including IRS rules that are less clear-cut. Nevertheless, if you know the rules, you may be able to use this strategy to save on taxes while staying invested in the fixed income markets. It can also be an opportunity to add higher-yielding securities to your portfolio and boost interest income going forward.
All major fixed income markets are down for the year
Source: Bloomberg, as of 11/14/2022.
Bloomberg US Agg 10+ Year Index (Long-term bonds), Bloomberg US Corporate Index (Corporate bonds), ICE BofA Fixed Rate Preferred Securities Index (Preferred securities), Bloomberg US Aggregate Index (Core bonds), Bloomberg US Corporate High Yield Index (High yield bonds), Bloomberg U.S. Securitized: MBS/ABS/CMBS and Covered Statis (Securitized bonds), Bloomberg US Treasury Index (Treasury bonds), Bloomberg US Treasury Inflation Notes Index (TIPS), Bloomberg US Agg 5-7 Year Index (Intermediate-term bonds), Bloomberg Municipal Bond Index Total Return Index Value Unhedged USD (Municipal bonds), Bloomberg US Agg Agency Index (Agency bonds), Bloomberg US Agg 1-3 Year Index (Short-term bonds), and Morningstar LSTA US Leveraged Loan 100 TR USD (Bank loans). Indexes are unmanaged, do not incur management fees, costs and expenses and cannot be invested in directly. For illustrative purposes only. Returns assume reinvestment of interest and/or dividends and do not assume taxes. Past performance is no guarantee of future results.
What is tax-loss harvesting?
Tax-loss harvesting is when you sell a security at a loss for tax purposes. You can use that loss to either:
- Offset realized gains elsewhere in your portfolio for this tax year (be aware that first you must offset short-term losses against short-term gains and long-term losses against long-term gains. Then any leftover losses can be used to offset remaining long- or short-term gains).
- If you have leftover losses, you can reduce your taxable income by up to $3,000 (this deduction is the same for all tax filing statutes).
- Carry the loss forward into another tax year and use it in the future.
For example, let's assume an investor purchased $10,000 of a hypothetical intermediate-term municipal bond mutual fund over a year ago. Due to the decline in the fixed income market, the value of that mutual fund today is $9,000. In this instance, an investor could sell the mutual fund for a $1,000 loss and use that loss to save on their tax liability. If they used the $1,000 loss to offset their other short-term capital gains, they could potentially save $370 on their tax bill assuming they were taxed at the top federal tax rate of 37%.
How does the wash-sale rule complicate things?
The wash sale comes into play if you realize a loss and then repurchase the same or "substantially identical" security within 30 days before or after the sale at a loss. Essentially, the loss is disallowed for tax purposes and the amount of the loss is added to the cost basis of the new purchase. Using our example above, assume that the price of the fund rose to $9,100 and the investor repurchased it shortly after selling it for $9,000. In this scenario, the original $1,000 would be disallowed and added back to the new cost basis, thus resulting a new cost basis of $10,100.
You can't avoid the wash-sale rule by selling a security at a loss in one account and repurchasing it within the 30-day window in another account. Nor can you avoid it by having your spouse or a corporation you control purchase the same or substantially identical security. The IRS considers the totality of your trades, not just on an account-by-account basis.
What if you don't want to be out of the market for a period of time?
One of Schwab's Investing Principles is that "time in the market is key." This can be especially true for fixed income investors because every day you're not invested is a day you're forgoing interest income, which can add up over time. If you don't want to be uninvested for the 30 days before or after selling the security at a loss, you'll need to purchase a security that is neither the same nor substantially identical.
Unfortunately, the IRS is vague in its definition of a substantially identical security. It's even more vague when it comes to defining fixed income investments that are considered substantially identical securities. In defining what substantially identical means, the IRS says that "you must consider all the facts and circumstances in your particular case."
It's clear that buying the exact same individual bond, mutual fund, or exchange-traded fund (ETF) meets the definition of a substantially identical security, but that's where the clarity ends. The IRS doesn't clarify, for example, whether two individual bonds from the same issuer that have different maturities, coupons, yields, and/or ranking in the capital structure would be considered substantially identical.
When it comes to mutual funds and ETFs, the rules are slightly clearer. Because fixed income mutual funds are a portfolio of bonds, two funds that have a similar investment mandate might not be considered substantially identical because they hold different securities. For ETFs, even if two funds track a similar but not identical index, they too might not be considered substantially identical because they track different indices.
How could this work in practice?
Let's return to our example above, in which an investor has a $1,000 realized loss in an intermediate-term bond mutual fund. Instead of rebuying the same mutual fund, they purchased an intermediate-term ETF that tracks a similar but different index. In this instance, they may be able to still realize the $1,000 loss while also not having to be out of the market for the 30-day period to avoid a wash sale. Because the two funds have a similar investment mandate, it's likely they would have similar returns going forward. To reiterate, the IRS considers all the facts and circumstances of a particular case to determine if a wash sale is triggered, so prior to making any portfolio changes for tax purposes, you should consult with your tax advisor.
Which fixed income securities should you consider selling?
Everyone's situation is going to be different and unique to their own financial situation, but here are some things to consider:
1. Start with securities that are at a loss. This may be obvious, but consider the value of your securities relative to your cost basis, not your original investment. Schwab clients can find the cost basis on the "positions" page on Schwab.com. Your cost basis may be different from your original investment amount due to factors such as amortization or reinvesting interest payments.
2. Look for securities that don't meet your investment goals. Beyond the obvious benefit of potentially paying less in taxes, utilizing tax-loss harvesting can also be an opportunity to better position your portfolio for the current market environment. We believe that the bulk of the move up in interest rates is likely behind us and that investors should extend the average duration of their bond holdings to take advantage of the recent move up. Evaluate your current holdings to determine if there's an opportunity to take a loss in short-term bonds and rebalance into some bonds that have a longer maturity for example.
We also believe that it makes sense to move up in credit quality and tax loss harvesting can provide an opportunity to sell lower-rated securities at a loss and move up in credit quality while potentially saving on taxes. From a tactical standpoint, it may make sense to reduce your holdings in lower-rated investments, take the capital loss for tax purposes, and reinvest in a higher-rated security. Given the large changes in interest rates this year, it may be the case that the new higher-rated bond yields more today than the original lower-rated bond.
For example, consider a five-year BBB-rated and AA-rated corporate bond.1 We will use two indices to represent these hypothetical bonds. At the beginning of the year, the index of five-year BBB-rated bonds yielded 2% and had a price of about 107.9. If an investor purchased $10,000 face value of the bond, they would receive an annual income of $200. As of November 10th, 2022, the price had fallen to about 94.4 due to the rise in interest rates. Bond prices and yields move in opposite directions. In this instance, if the investor sold the bond, they could realize a loss of roughly $1,350. If they took the proceeds and bought $10,000 of the higher rated AA bond, their new yield would be about 4.5% for an annual income of $450.
While each situation will be different, in this instance, the investor could use the $1,350 loss to offset some of their taxable income while also boosting their interest income from $200 per year to $450 per year.
What to do now
It's been a brutal year for fixed income investors but one that we believe won't repeat. The good news is that this year has presented an opportunity to utilize tax smart strategies and better position your portfolio for the future. Prior to making any changes for tax purposes, we suggest consulting with your tax advisor and/or reviewing IRS Publication 550.
1 The indices used in the hypothetical example are the USD US Corporate AA+, AA, AA- BVAL Yield Curve 5 Year and the USD US Corporate BBB+, BBB, BBB-, BVAL Yield Curve 5 Year. Prices are calculated assuming a settlement date of 11/10/2022, a coupon of 4%, and a maturity date of 11/10/2026, and semi-annual coupon payments.
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Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.
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Treasury Inflation Protected Securities (TIPS) are inflation-linked securities issued by the U.S. government whose principal value is adjusted periodically in accordance with the rise and fall in the inflation rate. Thus, the dividend amount payable is also impacted by variations in the inflation rate, as it is based upon the principal value of the bond. It may fluctuate up or down. Repayment at maturity is guaranteed by the U.S. government and may be adjusted for inflation to become the greater of the original face amount at issuance or that face amount plus an adjustment for inflation.
Preferred securities are often callable, meaning the issuing company may redeem the security at a certain price after a certain date. Such call features may affect yield. Preferred securities generally have lower credit ratings and a lower claim to assets than the issuer's individual bonds. Like bonds, prices of preferred securities tend to move inversely with interest rates, so they are subject to increased loss of principal during periods of rising interest rates. Investment value will fluctuate, and preferred securities, when sold before maturity, may be worth more or less than original cost. Preferred securities are subject to various other risks including changes in interest rates and credit quality, default risks, market valuations, liquidity, prepayments, early redemption, deferral risk, corporate events, tax ramifications, and other factors.
Bank loans are typically below investment-grade credit quality and may be subject to more credit risk, including the risk of nonpayment of principal or interest. Most bank loans are floating rate, with interest rates that are
tied to LIBOR or another short-term reference rate, so substantial increases in interest rates may make it more difficult for issuers to service their debt and cause an increase in loan defaults. Bank loans are typically secured by collateral posted by the issuer, or guarantees of its affiliates, the value of which may decline and be insufficient to cover repayment of the loan. Many loans are relatively illiquid or are subject to restrictions on resales, have delayed settlement periods, and may be difficult to value. Bank loans are also subject to maturity extension risk and prepayment risk.
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