Fixed income tax-loss harvesting

Halloween typically offers both Tricks and Treats. One area where the holiday seems to be offering opportunities for Treats is within taxable accounts that hold fixed income portfolios invested before 2022.

Tax-aware advisors and many investment processes are all about tax-loss harvesting across taxable accounts. Tax-loss harvesting is the process of selling a taxable asset with a lower value than the original price paid for it. When the loss is realized (sold), it becomes a tax asset that can be used to offset against realized capital gains in the current year or carried forward into future tax years. These realized losses can have real economic value for taxable investors.

Much of the writing and actual loss harvesting seems to focus on the equity side of an investor’s portfolio. However, in a standard 60% equity/40% fixed income portfolio, this only addresses 60% of the portfolio. What about the 40%?

At Frontier Asset Management, we get the opportunity to evaluate and review many portfolios that are shared with us. I am surprised by how often we see losses sitting in fixed income bond funds that have not taken advantage of loss harvesting opportunities. The equities may have been harvested, but the bond losses remain and are waiting to be realized.

Why is this?

1. Much of the focus and writing on loss harvesting is on equities.
2. Historically, bond funds have reasonably steady Net Asset Values (NAV) maintained through time. Folks don’t think to look here. The same goes for individual bonds.
3. When you tax-loss harvest, you must reinvest the proceeds in an equally or more appealing alternative. If an asset manager is limited to only proprietary mutual funds, odds are they sell their Municipal Bond Fund to harvest the loss, but where do they put the proceeds? They want to keep the assets within their proprietary ecosphere. There is not a different fund to invest the proceeds in. Hence, the untapped losses lie there unrealized on many investor statements.

Why are there losses?

Typically, when interest rates go up, bond values go down. 2022 was a historic year for bond investors, and not in a good way. The Fed’s aggressive rate increases to fight inflation left a mark on fixed income that year.

Below is a hypothetical view of a High Yield Municipal Bond Fund’s Net Asset Value:

Even with the attractive returns of late for this hypothetical fund, the quarter ending NAV of $10.12 remains 10% lower than many NAV dates in 2019, 2020 and 2021 and some materially more than 10%. An entry point on these days may equal tax loss harvesting opportunities.

How to identify?

Look at the monthly statements for your clients and prospects. Look for the recent market value and adjusted cost basis for the investment. Most statements will show the unrealized gain/loss. Many investor statements still have these losses waiting to be realized.

For performance reports that show After-Tax Returns at the mutual fund level, anytime you see an After-Tax Post Liquidation Return that is higher than the Pre-Tax Return, odds are there are losses that can be harvested. Why? Selling the fund will realize a loss and the monetary value of the tax not paid is added to the return. For fund families that publish these returns and claim tax awareness, they are unintentionally showing you tax assets for their funds that can be harvested.

Frontier Asset Management’s approach

At Frontier, we do not use any proprietary funds in our Tax-Managed Strategies. We have no problem removing a fund (partially or wholly) and immediately reinvesting these proceeds into equal or higher confidence managers. And often, these trades allow us to reposition the portfolio based on our forward-looking asset class return projections and correlations. We believe it’s best to be a risk manager – not a risk taker.

We harvested losses in 2022 across all our funds – regardless of asset class. We evaluate the mutual fund and ETF holdings across our taxable strategies to look for opportunities throughout the year. While 2024 has seen attractive returns for most all equity and bond funds, our process allows us to be ready for when the inevitable pullback happens – regardless of asset class.

As 2024 winds down this fourth quarter, don’t miss the opportunity to find the “Halloween Treats” of tax losses waiting to be harvested. If you are using an outside money manager to do the loss harvesting, don’t let them pull any “Halloween Tricks” by not looking at the total portfolio.