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Applying Tax-Loss Harvesting to a Fixed Income SMA

Bernie Scozzafava photo

Bernie Scozzafava, CFA

Director, Quantitative Research and Portfolio Management

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Evan Rourke photo

Evan Rourke, CFA

Director, Portfolio Management

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Tax-loss harvesting strategies are not just for stock portfolios. Learn how this often-misunderstood concept can be deployed to fixed income SMAs on a year-round basis. 

The end of the year often marks the arrival of the first frost, the airing of new holiday commercials, and the onset of tax-loss harvesting (TLH) requests. Tax-efficient investing is a well-established strategy in the equity markets, but the practice is now gaining wide adoption by managers of fixed income separately managed accounts (SMA). 

While the challenges of using bonds to implement a TLH strategy are greater, and the contribution to after-tax returns lower than it usually is with stocks, the benefits remain material, especially considering today’s low-yield environment. The potential for rates to trend higher as the Federal Reserve gradually tapers its bond-purchasing program could create the opportunity for an investor to reduce their overall tax payment by harvesting losses in a systematic way, while still benefiting from higher reinvestment rates. Since the application of tax management to a bond SMA may still be a novel concept to some investors, this blog post addresses the benefits of TLH strategies to a bond portfolio on a year-round basis.

What are the benefits? 
Investors appreciate that what matters is after-tax portfolio returns. A successful TLH trade aligns realized losses and gains to minimize capital gains taxes while maintaining a fixed income portfolio’s yield target, risk metrics, and diversification criteria. What sounds like a simple strategy can become quite complex when evaluating wash-sale rules, transaction costs, and—most importantly—reinvestment opportunities. To be most effective, TLH should be applied with a rules-based approach that considers an investor’s current tax bracket, as well as each sector’s unique tax treatment and liquidity characteristics. For example, if a loss is realized on a corporate bond position, reinvesting the proceeds in a discount bond will maximize the tax benefit, whereas the exact opposite could be true if a municipal bond is harvested. As long as loss triggers are set accordingly to cover transaction costs, the systematic application of TLH in a bond portfolio should only be additive to a portfolio’s after-tax return.  

Company-specific factors are often the primary driver of opportunities for TLH in an equity portfolio—inevitably some stocks will decline in price even during years when the broad indexes post substantial gains. For bond investors, periods of rising interest rates typically represent the most favorable environment in which to harvest losses. These events may occur less frequently and, to an investor’s benefit, they usually are associated with periods of strong economic growth, when such losses can be used to offset gains realized in an investor’s stock portfolio. Our backtest studies show that even high-quality bonds that deliver dependable income can be used to add 10 to 30 basis points (bps) to annual, after-tax performance. Municipal bonds are at the higher end of the range and should be an investor’s preferred TLH asset class due to their favorable tax treatment. The benefit isn’t as great for corporate bonds, which are taxable. TLH lowers the portfolio’s cost basis, which will eventually result in an offsetting gain when the new positions mature. 

From a research perspective, a backtest study will accurately assess the benefits of a TLH strategy because it relies on actual security data. However, following the recent high inflation prints and the Fed’s plans to reduce its security purchases, an investor may have a less constructive outlook for interest rates than reflected in historic data. We expect municipal and corporate bond yields to trend higher in the new year. They are less likely to spike as significantly as they did during the 2013 Taper Tantrum. Investors have since become confident that the Fed will scale back its purchases in a measured way so as not to disrupt the financial markets. Currently, the consensus outlook is for two 25 bps rate increases in 2022. Under such a scenario, a five-to-15-year A municipal ladder would produce 31 bps in annual tax alpha over the next five years. 

Discover the potential benefits of tax-loss harvesting to fixed income SMAs

Why year-round TLH?
Previously, TLH strategies were implemented at year’s end as a means of offsetting capital gains. This was generally a reactive process. Year-round TLH is a proactive process that realizes tax losses over the course of the year, which can then be applied to minimize the tax impact of realizing gains or be carried forward, if necessary. The benefit may not be realized in the current tax year, but, under current tax law, it’s never lost. 

Year-round TLH avoids some of the pitfalls of year-end TLH, the biggest of these being that year-round TLH allows for the realization of losses when they are available to take. The opportunity may not be there at year’s end. Typically, dealers operate on a calendar year, so heading into year-end they tend to pare back risk and market liquidity can suffer. The benefits of year-end TLH can be diminished due to the widening out of bid/offer spreads as liquidity dries up. While year-end TLH can be something akin to a crowd trying to move through a revolving door, year-round TLH avoids this issue completely. In addition, issuance often dries up at year’s end as issuers close their books or shift into a holiday mode. For markets like municipals, where new issues generally come at a concession, TLH in a period of reduced issuance is suboptimal. This is not the case with year-round TLH.

When year-round TLH is part of a systematic process executed by an asset manager, investors’ positions can be aggregated, avoiding the haircuts that are common when selling small lots. In addition, a well-structured process should result in minimal cash buildup. Both of these benefits are more difficult to achieve with a smaller window, like the one available with year-end TLH. Aggregating becomes trickier if active consent is required to harvest tax losses, and a thinner, less liquid market will have fewer options for replacement purchases.

The bottom line
Our backtest studies have quantified what a growing number of investors have come to appreciate—that TLH in a fixed income SMA can materially reduce an investor’s overall tax bill. TLH is a customization option that can only be realized in an SMA—TLH benefits aren’t available in a commingled mutual fund or ETF. 

Just as online shopping gives consumers access to the best Black Friday deals without the need to awaken before dawn, systematic TLH enables investors to realize the best opportunities to harvest losses throughout the year without the concern that thin, end-of-year markets will impact a portfolio’s yield and risk profile. 

Investment strategies that seek to enhance after-tax performance may be unable to fully realize strategic gains or harvest losses due to various factors. Market conditions may limit the ability to generate tax losses. TLH involves the risks that the new investment could perform worse than the original investment and that transaction costs could offset the tax benefit. Also, a tax-managed strategy may cause a client portfolio to hold a security in order to achieve more favorable tax treatment or to sell a security in order to create tax losses. Prospective investors should consult with a tax or legal advisor before making any investment decision. See Disclosure section for additional information. 

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