INSIGHTS

On December 01, 2014

Viewpoints from AAM - Tax Swaps Provide Portfolio Restructuring Opportunities

Although losing money in an investment does not put one in a festive mood, at least the potential to recover some of the loss by pairing the loss against a gain is a gift of sorts. However, why pay a capital gains tax when it can be avoided? Another reason for tax swaps – which is not often discussed, but I feel is very important – is the opportunity to restructure/rebalance a portfolio at the same time.  

Brian Gilbert wrote an excellent piece on tax swaps, “Tax Swap Season is Here,” and the various opportunities for restructuring client portfolios (Credit Quality Swaps, Duration Swaps, Asset Allocation Swaps, etc.). Based on that piece, I would like to offer a couple ideas.

With strong bond and bull equity markets, the greatest opportunity for tax swaps may be in the credit events that have already occurred. For example, in the municipal market, if an investor owns or owned Puerto Rico bonds, or most bonds associated with Detroit, there might be a loss involved. In the corporate bond markets the same may be said for investors that own issuers. These are examples of potential credits that may have gone down in price; however, it does depend on when the bonds were purchased and the cost basis.

The sell side, or realizing the loss, is the easy part. Choosing what to sell that has a profit and where to re-invest the proceeds is not as easy. If the investor wishes to restructure their equity allocation by adjusting sector concentration or increasing dividend income, then consider selling the equities targeted, book the profit and reallocate to help achieve the goals of the investor.

Regarding bond portfolios and reallocations, again, the sell side to realize the loss is relatively easy; sell the bond and realize the loss. There are many ideas on where to be positioned in the bond market. I would like to suggest this idea: consider taking profits on the short maturity bond holdings and reposition in the short- to medium-range maturities, say five to seven years out. The very short maturities which many deem the “safest” in a rising interest rate scenario may also be the most vulnerable, if and when the Fed raises rates. The Fed can only control short-term rates and with rates at essentially zero, rates on the short end will go up. The question is what happens to rates as you go out the yield curve. No one can predict that with any certainty. There are those who believe that the longer part of the curve does not have to go up in yield just because the short end does. Shifts in the yield curve are typically not parallel.

For example, recently, Jeffrey Gundlach, a well-respected portfolio manager, suggests that the yield curve will flatten in 2015. With the Fed potentially raising rates on the short end and other factors keeping the longer end of the rate curve lower, the yield curve will flatten. If you envision a teeter totter, if one end goes up, the other end goes down relative to the other side; then the teeter totter – or curve – flattens. It follows that somewhere between the short end and long end of the curve should stay relatively less volatile than either end. That is where I suggest an investor considers reinvesting; sell the very short end, take profits and reinvest around five to seven years, lock in a higher yield and see what happens in 2015.

This is one of several swap strategies. The point is take advantage of end-of-year tax swap opportunities, where appropriate; reposition your portfolios to suit the investor’s objectives, but get it done in the next couple weeks.

Happy Holidays!

CRN: 2014-1107-4501 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.

This commentary is for informational purposes only. All investments are subject to risk and past performance is no guarantee of future results. Please see the disclosures webpage for additional risk information. For additional commentary or financial resources, please visit www.aamlive.com/blog.