The final quarter of the year brings a change of seasons with vibrant fall foliage, football games, Thanksgiving celebrations, and the conclusion of the calendar year. For financial advisors, this marks the period when they may look for tax-loss harvesting opportunities within taxable accounts, with a focus primarily on equity and equity-oriented investments. Discussions and case studies regarding tax-loss harvesting commonly revolve around stocks, while fixed income and bond holdings are often overlooked.
Don’t forget the 40 of the 60/40
By definition, the 40 of a 60/40 balanced portfolio is allocated to fixed income. There is nothing that precludes fixed income from being considered for tax-loss harvesting, it’s just that bonds historically haven’t provided the opportunity. Considering the challenging returns observed across fixed income the last three years, there may be attractive loss-harvesting opportunities for many taxable accounts.
The Net Asset Value (NAV) or share price for fixed income funds (as well as all funds) represents the dollar value of a single share in that fund. With the historic increase in interest rates over the last 18+ months, many bond funds have experienced a material reduction in their NAV. This reduction could be an opportunity for tax-loss harvesting, which involves:
- Selling the fund where the NAV is lower than purchase price.
- Creating a tax asset for your client.
- Simultaneously moving to an investment opportunity of equal or higher conviction.
When done properly, one could remain fully invested while freeing up the loss that could be used to offset other gains in the portfolio, either in the current year or into future years.
The following illustration serves to demonstrate the size and timing of this opportunity. If an investor purchased the hypothetical fixed income fund between September 2019 and January 2022, their NAV could have decreased by 10% or more. This presents a potentially attractive moment to actively realize the loss and create a tax asset.
To provide further context on the magnitude of the decline in NAV, take a look at the drawdowns depicted below for both the U.S. Aggregate and Municipal Bond Indexes. This offers a sobering perspective on the journey bond investors have experienced over the last 18+ months.
Why might some investment processes overlook this tax loss harvesting opportunity?
First, let’s acknowledge that this recent pullback in fixed income is (thankfully) rare. These are historic pullbacks for bonds, and both investors and much of the investment industry are unaccustomed to such significant pullbacks in fixed income investments. Although rare, they are indeed a reality.
Certain investment strategists may face limitations when it comes to engaging in loss harvesting for fixed income. Loss harvesting involves selling one security and simultaneously purchasing another. To do this, you need another fund to buy. If a strategist is limited to only proprietary funds or a limited list of approved funds, they may not have suitable replacements for their bond funds. As a result, these losses remain stagnant on client statements, waiting to be set free.
The loss harvesting trade should not be an end in itself. While the tax-loss is powerful, the trade should also reflect the opportunity to reposition the portfolio to better manage risk in the current environment and/or to a higher confidence investment alternative.
At Frontier Asset Management, we use an open architecture investment approach. We don’t have any proprietary funds nor are we constrained by an approved fund list. This flexibility allows us to consider virtually the entire universe of active funds or ETFs and/or passive funds or ETFs. Throughout 2022, we were actively engaged in loss harvesting across the various fixed income funds we used. It was nothing personal against the funds, but as the saying goes, you want to “make hay when the sun shines,” and the recent developments in the fixed income markets of late have kept us busy on behalf of our investors.
Exclusive reliance on the information herein is not advised. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. References to future returns are not promises or even estimates of actual returns a client portfolio may achieve. Assumptions, opinions and estimates are provided for illustrative purposes only. They should not be relied upon as recommendations to buy or sell any securities, commodities, treasuries or financial instruments of any kind. This material has been prepared for information purposes only and is not intended to provide, and should not be relied on for, accounting, legal, investment or tax advice.
Frontier does not provide tax advice. Please consult with a CPA for recommendations pertaining to individual circumstances.
Tax loss harvesting is an investment strategy designed to optimize your tax liability by selling investments that have experienced a loss to offset capital gains and reduce your taxable income. While this strategy can provide tax benefits, it’s essential to understand the potential risks and limitations associated with it. Tax loss harvesting involves selling assets, which may trigger capital gains in the future when markets recover. This could potentially offset the initial tax benefits. The IRS has specific rules (wash sale rules) that prevent you from repurchasing the same or substantially identical securities within 30 days of selling them at a loss. Violating these rules can disallow the tax loss deduction. Tax laws are subject to change, which could impact the effectiveness of tax loss harvesting strategies. The benefits of tax loss harvesting may vary based on your individual tax situation. Consult a tax advisor or financial professional to determine its suitability for your needs.
Hypothetical performance results have many inherent limitations, some of which are described below. No representation is being made that any account will or is likely to achieve profits or losses similar to those shown. In fact, there are frequently sharp differences between hypothetical performance results and the actual results subsequently achieved by any particular trading program. One of the limitations of hypothetical performance results is that they are generally prepared with the benefit of hindsight. In addition, hypothetical trading does not involve financial risk, and no hypothetical trading record can completely account for the impact of financial risk in actual trading. For example, the ability to withstand losses or to adhere to a particular trading program in spite of trading losses are material points which can also adversely affect actual trading results. There are numerous other factors related to the markets in general or to the implementation of any specific trading program which cannot be fully accounted for in the preparation of hypothetical performance results and all of which can adversely affect actual trading results.
Frontier Asset Management LLC is a Registered Investment Adviser. The firm’s ADV Brochure and Form CRS are available at no charge by request at firstname.lastname@example.org or 307.673.5675 and are available on our website www.frontierasset.com. They include important disclosures and should be read carefully.