December is typically the time of the year when the term “tax-loss selling” comes into play. If an investor has sold any asset, including stocks, bonds, real estate, or other tangible property for a gain during the course of any calendar year, from a tax management perspective, it serves as a benefit to offset those gains by selling assets currently priced lower than when purchased.
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Capital gains and losses are reported on Schedule D of an individual’s federal tax return with net gains increasing one’s tax liability. Thus, there is a logical impetus to keeping the bottom line number on Schedule D as low as possible.
In a year where long-term interest rates have posted meaningful gains, it’s possible that individual bonds purchased over the past couple of years may be sitting at a loss, making them ideal tax loss selling candidates. Even if the percentage or nominal amount of the loss is not particularly bothersome, the simplicity of a bond swap may nonetheless make sense from a tax efficiency perspective.
Understanding A Tax Efficient Bond Swap
When a bond swap for tax purposes is executed, one bond is typically sold at a loss and another bond is purchased to replace the existing bond. The new bond may have similar, but not identical characteristics to the bond being sold at a loss, unless the identical bond is purchased more than 30 days following the sale of the original bond.
For example lets say we purchased $25000 of a hypothetical BBB corporate bond two years ago at a 6% coupon with a maturity of 2031 (20 years) at par, which pays us $1500 a year in interest. With the rise in rates this year, our bond is now trading at a price of 90 (10 percent lower) on the open market. If we execute a bond swap we could take a long-term capital loss of $2500, a result of the difference between our purchase price of $25000 and sales price of $22,500 ($25,000 face value X 90%).
Before we sell that bond at a loss, we identify another corporate bond from another issuer with similar credit quality, coupon rate, maturity, and price to the bond we are considering selling. To fully execute the swap, we sell our existing bond at a loss and purchase the new bond at a similar price with the funds we receive from the sale, thereby continuing to receive roughly the same amount in interest payments.
Other Types of Bond Swaps
While bond swaps are a strategically smart tax move, they can also be utilized at any time to improve or change the overall profile of an individual bond portfolio. For instance, if one’s perception of the economy starts to decline, it may be a prudent move to upgrade the credit quality of the portfolio. So one could sell a BB bond at a profit and use those funds to buy a AA bond with similar maturity. While income will be sacrificed, the quality of the portfolio goes up. If one feels as though duration/interest rate risk is going down, it may make sense to sell a bond maturing in less than five years and replace it with one with similar credit quality that goes out much longer and provides higher yield.
An investor could also decide to execute a swap that incorporates both credit and duration alterations. In our tax efficient example from earlier we could sell our BBB, 20 year bond and decrease credit quality, going to a B, but decreasing maturity length, to say 8 years. By adjusting both credit and duration parameters, it’s possible we could still find a bond that would replace the interest income of the old bond.
If one is sitting on a loss in a bond fund, whether it is one that is open- or closed-ended, or an ETF, a similar swap-like strategy can be employed. One can raise cash with the at-a-loss fund and simply find another product with a similar (or dissimilar) investment mandate or yield. If you own an iShares ETF at a loss, you might be able to find a very similar Vanguard ETF.
The one caveat with bond funds is that some may distribute end-of-the-year capital gains to investors due to the pass-through rules associated with pooled products. And some of them may distribute the gains at varying times of the month. Thus, if you selling one to buy another you should try to make yourself aware if the company(s) you are dealing with have announced distributions or not, and how much they are. Due to the tax consequence, one should attempt to avoid buying into a capital gains distribution.
While tax loss commentary tends to revolve around equity markets, fixed income investors would be well advised to review their portfolios as well and execute bond swaps in an effort to maximize annual tax efficiency. There’s no sense leaving paper losses on the table and ponying up more to Uncle Sam than is absolutely necessary.
About the author:
Adam Aloisi has over two decades of experience investing in equities, bonds, and real estate. He has worked as an analyst/journalist with SageOnline Inc., Multex.com, and Reuters and has been a contributor to SeekingAlpha for better than two years. He resides in Pennsylvania with his wife and two children. In his free time you may find him discussing politics, playing golf, browsing antique shops, or traveling.
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