Capitalize on periods of volatility, and keep portfolios fully invested. Learn how year-round tax-loss harvesting can make that happen.
The past year clearly demonstrated the advantages of tax-loss harvesting (TLH). Parametric has produced several articles presenting the case for systematic TLH in corporate and municipal separately managed accounts (SMAs). Tax-loss harvesting can significantly reduce income taxes owed on realized gains, keep investors fully invested, and create larger after-tax compounded returns compared with accounts that don’t pursue the strategy. The Federal Reserve’s efforts to reduce inflation led to a historic rise in Treasury rates and generated painful losses for fixed income portfolios. One of the year’s few silver linings was the after-tax alpha generated by the systematic TLH strategy.
Systematically harvesting losses over the course of the year can produce a tax asset, or realized losses, and can add considerable after-tax alpha to after-tax returns when used to offset future realized gains. These strategies are unique to SMAs because they can present more opportunities to harvest losses than mutual funds or exchange-traded funds.
Bond prices are negatively correlated to increasing interest rates, and investors certainly felt that impact in 2022. Rising rates are typically positively correlated with periods of economic strength, which coincide with gains in equity prices. This environment presents investors with the opportunity to generate a tax-loss asset in fixed income portfolios, potentially reducing the taxes on other portfolio gains now and in the future. However, both bond and equity prices declined in 2022. There may have been few gains to offset because of this, but the tax asset remains indefinitely when investors harvest losses. Let’s look at the best strategies for TLH that may allow investors to reap valuable tax benefits in a bear market.
Advisors typically review their portfolios for TLH strategies in December. But the strategies become much more effective when assessed in a proactive, systematic manner throughout the year. This is particularly true in fixed income portfolios, where TLH opportunities are mostly driven by changes in interest rates and yearly rate peaks have historically been distributed throughout the calendar year. Investment-grade (IG) corporate bond index yields have only peaked in December on three occasions over the last 33 years. Municipal index yield peaks are historically evenly distributed throughout the year as well, and they only peaked in December twice in the last 22 years. Systematic loss harvesting ensures that losses during the rate peak, where losses are typically greatest, are realized no matter when it occurs. Spreading the trades throughout the year also avoids the poor liquidity conditions that generally occur late in the year. Many accounts that used this strategy in their portfolios had the opportunity to harvest losses in every month of 2022 even though the opportunities to harvest losses in fixed income are relatively rare.
What should investors consider when choosing a TLH strategy?
TLH strategies are a long-standing practice in equity portfolios but a relatively new development in fixed income SMAs. Wide bid-ask spreads and liquidity considerations historically precluded efficient execution of the strategy. Electronic execution has dramatically decreased corporate and municipal bid-ask spreads over the last several years. Transaction costs are further reduced by aggregating large blocks of bonds from many SMAs to produce large institutional-sized trading positions. Turnover numbers for many SMA investors have been notably higher than in previous years due to the extreme number of TLH opportunities. Advisors should apply TLH with a rules-based approach that accounts for each sector’s unique tax treatment and liquidity characteristics.
While we periodically work with individual financial advisors and clients who are looking to recognize specific TLH opportunities in their portfolios, we would encourage them to consider using systematic and ongoing tax-loss harvesting whenever available. The economies of execution and scale, the ability to execute trades through the year, and most importantly, the after-tax alpha available to those following the systematic program are significant.
How can investors create unique opportunities from volatility?
Index yield to worst
The bottom line
The volatility of 2022 is unlikely to abate this year. Interest rates are likely to rise and fall, creating periods of both positive and negative performance over the course of the year. Parametric can help advisors find opportunities to continue year-round tax-loss harvesting in fixed income portfolios, even if 2023 performance returns to historical norms, providing extra protection in a volatile market.
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. Tax-loss harvesting 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.