INSIGHTS

On November 01, 2023

Tax Loss Selling: A Secular Opportunity to Reset Bond Portfolios

With the price of all debt instruments suffering and on their way to a historic three-year drawdown, fixed income investors are arguably at one of the more tax-advantaged inflection points. Tax loss selling is a tool whereby investors can sell fixed income investments at losses to help offset portfolio gains, while recalibrating their portfolio to represent the current and projected environment. Portfolio recalibration could result in improvement of overall credit quality, shifting maturity, and/or adjusting the coupon to a more relevant current coupon compared to when it was purchased. 

With the onset of inflation late in 2021, a not-so-new risk emerged in a powerful way. Higher inflation led to higher rates which broke a four-decade pattern of lower new-cycle rates; however, we believe the next decade or more likely will represent cycles seen from 1960–1991. Simply put, shorter expansions, a changing environment for more dynamic allocations, and a renewed focus on income could be in store.

To-date, the Federal Reserve has increased interest rates from 0.00% to 5.50% in just under two years, which has reset the entire fixed income market. While there are many metrics to illustrate just how profound this change has been, perhaps the most notable is the number of months the Bloomberg US Aggregate Bond Index (the broadest of the US bond indexes) has not posted a new high. In fact, it has been 38 months without a new high, and we are currently 16% below a new high. Previously, the number of months without a new high stood at 16!

The timing of executing a bond swap is another important component. As we have detailed, the drawdowns have been severe in the bond market and as such, markets tend to hit more liquidity constraints closer to the end of the year. To mitigate this, tax swaps are typically facilitated in November to avoid potential bid-side challenges at year-end. 

Below is an example of a hypothetical tax swap to highlight the potential opportunity to harvest a loss.

In this example, we will assume Bond A (BBB) was purchased two years ago at par at $100,000. The purchase price yield was 3.00%, equaling a dollar price basis of $100. The execution of swap assumes a settlement date of today at current market levels, assuming a reasonable cost of execution. The results of this hypothetical tax swap are as follows:

• The investor realizes a capital loss of $4,000 after adjusting for the cost basis of the security.
• The investor maintains the credit quality of the original security slightly.
• The investor increases their annual income.
• The investor contributed a minimal amount of cash to execute the swap.
• Investor extends maturity by approximately 2.75 years.

In determining if a tax swap is prudent for you, it is vital to engage with your tax attorney and advisor on identifying the best path to potential benefits. Historically in a tax swap, it has been seen as acceptable to alter the issuer, the maturity, and the coupon to avoid falling into the wash rule which could remove the benefit of harvesting tax losses. 

The wash rule, in its simplest form, is when an investment is sold at a loss and then a “substantially identical” security is purchased within a timeframe of 30 days. If this occurs, the loss generally cannot be claimed for tax purposes. The IRS is relatively vague in defining what constitutes a “substantially identical” security, which is why changing at least two of the three criteria of a bond purchase is important. Generally, the three criteria are change in issuer, change in coupon, and/or change in maturity. 

With one of the largest drawdowns in recent memory in the fixed income and equity markets, the opportunity to harvest losses and reset portfolios for a significant market shift prove advantageous in consultation with your financial advisor and tax attorney. 

CRN: 2023-1012-11174 R

Advisors Asset Management, Inc. and its representatives do not provide tax advice. Laws applicable to tax-related investment strategies can be complex and are subject to change. You should consult your own tax advisor before making any tax-related investment decisions.

All information and opinions contained in this publication were produced by Advisors Asset Management, Inc. (AAM) and other sources believed to be accurate and reliable. By providing this general information, AAM makes neither a recommendation as to the appropriateness of investing in fixed income securities or using a tax swap investment strategy. Tax swaps are not for everyone. Using a tax swap strategy has many risks so it is recommended that you seek counsel from both a financial professional and a tax advice professional. AAM is not providing any specific investment advice for any particular investor. Additionally, due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources are required to make informed investment decision based on the investor’s suitability specifications. AAM and its representatives do not provide tax advice.