Fixed income is back… at least when it comes to yields. The big bond rout of 2023 caused by the Fed’s action on interest rates has pushed yields and prices down. The problem is that despite the high yields, bond prices have continued to be flat in some market segments, moving lower. When it comes to total returns, bonds are at a loss.
But fixed income investors may still have a silver lining.
That comes courtesy of taxes. Now could still be a good time to tax-loss harvest your fixed income portfolio before the Fed acts on rates. Selectively pruning a portfolio to take advantage of some of the tax benefits makes a ton of sense.
A Quick Primer on Tax-Alpha
There’s an old investing adage that says, “It’s not what you earn, it’s what you keep.” Uncle Sam and his agents always have their hands in the cookie jar. Effective tax management is key to unlocking extra returns. This includes asset location and managing long-/short-term capital gains.
But losses also play into effective tax management. That’s what tax-loss harvesting does.
Tax-loss harvesting involves selling those stocks, funds, or assets that are currently showing a ‘paper’ loss in your portfolio. That may be difficult to do psychologically, but it makes a lot of sense overall.
The benefit is that those losses can be used to offset booked gains in other positions. Even better is that if your capital losses exceed the gains or if you have no capital gains in a year, $3,000 worth of those losses can be used to reduce your ordinary income. And if you lose more than $3,000 on a stock, the excess can be pushed into the future to offset capital gains and ordinary income later on.
Most investors focus on their equity positions when it comes to tax-loss harvesting. After all, stocks tend to be more volatile than bonds. However, bond losses can also be harvested to reduce taxes.
Bonds Are Losing Money
Right now, a variety of fixed income asset classes are still offering the ability to lock in those losses to lessen taxes today and in the future.
Bonds are certainly back on the income side of the equation with yields hitting levels not seen since the Great Recession. However, when it comes to price, they are still struggling. Many analysts and investors assumed that the Fed would have already been done with its interest rate hiking scheme. Originally, four cuts were on the docket for this year. However, thanks to stubbornly high inflation and a still strong economy, the Fed has continued to kick the can on cutting rates.
For bond prices, that’s been a hard nut to crack.
Looking at the sector benchmark—the Bloomberg U.S. Aggregate Bond Index (Agg)—more than 75% of the 10,000+ bonds in the index are currently trading at a loss. This is despite more than $77 billion in inflows to vehicles tracking the index this year. The longer term has not been wonderful for bondholders. Looking at the data, State Street shows that had an investor purchased the Agg on any day over the last 10 years—assuming just one buy and hold—98% of the potential purchase would be currently sitting at a loss. The average loss? 15%. 1
Losses on bonds extend beyond the benchmark Agg as well. This chart from State Street shows that nearly all segments of the bond market are currently trading for losses. Some normally steady sectors like investment-grade corporate and municipal bonds have over 90% of their constituents currently at losses.
Source: State Street
Looking at bond ETFs, data shows that of the funds with at least a one-year operating history, 80% are trading at a loss year-to-date, while 66% have losses over the last 12 months.
Time to Prune
Given that you’re most likely sitting at a loss on your bond portfolio, now could be a good time to sell or prune your exposure to certain segments of the market. That may be mentally hard to do, but it makes sense from a return and tax point of view. Moreover, there are ways to reduce taxes and still own bonds/fixed income assets.
That comes down to harvesting losses and then tax swapping.
Harvesting is the act of selling your losers to book the losses for tax purposes. What comes next is the swap piece. The IRS has something called the wash rule. Here, investors can’t sell something at a loss and immediately purchase a ‘substantially identical’ investment within 30 days of the sale. The ‘substantially identical’ part is pretty narrow in terms of definition.
For example, if you owned an individual Walmart bond, you could sell it and then buy a broader corporate bond ETF. Even though Walmart’s IOU is a corporate bond and most likely in the ETF, the IRS views these as two different investments. The same could be said for selling shares of a broader bond ETF that owns various sectors and buying individual ETFs covering these sectors. Likewise on the reverse. Going from active to passive or vice versa also can work.
Right now, investors still have an interesting opportunity to sell losing bonds and then buy back some. With that, investors can still potentially profit on the income side of the bond equation while removing some of the price issues. And if the Fed finally cuts rates and bond prices move up, investors will be able to capture those gains, with some tax savings potentially waiting in the wings.
Implementing the harvest and swap is pretty easy these days. Thanks to modern account requirements, brokerage accounts are required to track loss and lot information for all traders and investors. Good brokerages will allow you to simply see this info and make your sales accordingly.
Need some harvest inspiration? These ETFs are some of the worst performers over the last year.
Bond ETF Candidates for Tax-Loss Harvest
These funds were selected based on their year-to-date (YTD) negative total returns and can be typical candidates to implement a tax-loss harvesting strategy. They are sorted by their YTD loss, which ranges from -1.9% to -7.5%. They have expense ratios between 0.03% to 0.35% and assets under management between $31M to $8.77B. They are currently yielding between 0% and 4.5%.
| Ticker | Name | AUM | YTD Total Ret (%) | Yield (%) | Exp Ratio | Security Type | Actively Managed? |
|---|---|---|---|---|---|---|---|
| GOVZ | iShares 25+ Year Treasury STRIPS Bond ETF | $241M | -7.5% | 4.1% | 0.15% | ETF | No |
| ZROZ | PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF | $1.25B | -7.5% | 3.9% | 0.15% | ETF | No |
| IGOV | iShares International Treasury Bond ETF | $508M | -5.7% | 0% | 0.35% | ETF | No |
| BBLB | JPMorgan BetaBuilders U.S. Treasury Bond 20+ Year ETF | $31.2M | -3.6% | 4.5% | 0.07% | ETF | No |
| SPTL | SPDR® Portfolio Long Term Treasury ETF | $8.77B | -2.7% | 3.8% | 0.03% | ETF | No |
| LEMB | iShares J.P. Morgan EM Local Currency Bond ETF | $434M | -2.6% | 1.4% | 0.30% | ETF | No |
| TLH | iShares 10-20 Year Treasury Bond ETF | $7.99B | -1.9% | 4.1% | 0.15% | ETF | No |
In the end, bonds have been a losing proposition in the current environment, with losses extending across the various fixed income sectors. But investors may not need to fret. Tax-loss harvesting could turn losses into valuable tax gains. And with the ability to swap into different segments of the bond universe using an ETF, they can still gain valuable current yields. That’s a rare win-win in the investment universe.
The Bottom Line
Despite their higher yields, many bonds are still sitting at losses. For investors, this is a rare opportunity to tax-loss harvest those losses and turn them into gains. By selling their losers and buying a different set of bonds or funds, they can still lock in yields, while producing some hefty tax savings.
1 State Street (May 2024). Bond Losses Create Tax-loss Harvesting Opportunities…Yes, NowYield.