Talking Taxes: Capital Gains in Bond ETFs

It’s tax time again!  Don’t worry, not for you – you still have couple of months.  Rather it’s time for mutual fund and ETF managers to communicate information about upcoming capital gains distribution payments to investors.

This year, iShares funds were again very tax efficient, with only 5 of our 280 funds distributing a gain.  What’s interesting is that all 5 ETFs were in the fixed income category.  Looking back, this is a trend we have seen over the past few years – fixed income funds have been more prone to distributing cap gains than their equity cousins.  Which of course raises the question, why?

First off, let’s quickly review what causes a fund to make a capital gains distribution. A fund realizes a capital gain or loss every time it trades a security.  If a security has risen in price since it was purchased, there is a gain.  If it has fallen in price, there is a loss (for simplicity I will ignore amortization and other changes to cost basis). At the end of the tax year, the gains and losses from all the individual security trades in the fund are tallied up, and if the fund is in a net gain position it must distribute that gain to fund holders.

Whether a gain is paid and, if it is, the magnitude of that gain, depends on a number of factors:

  • Structure (cash or in-kind). Because cash transactions (exchanging cash for securities and vice versa in the creation and redemption process) are considered taxable events, funds that transact in cash generally are subject to increased instances of realized gains.  Most traditional mutual funds work this way, while most ETFs use an in-kind, securities-for-securities exchange method, which generally translates to fewer instances of realized gains.  For a comparison of the other differences between ETFs and mutual funds, click here.
  • Fund turnover. Funds that frequently buy and sell holdings are generally more susceptible to realizing gains.  This is less of an issue with index-based ETFs and mutual funds, since most indexes tend to have relatively low portfolio turnover.
  • Corporate actions. The terms of a merger, acquisition or tender offer can have tax implications.
  • Upward market movement. It’s sometimes forgotten, but capital gains are the unfortunate side effect of positive performance.  When securities in a fund are up, the trading of those securities will trigger a gain.

Now let’s talk about fixed income funds specifically.  Over the past few years we have seen steadily declining interest rates, which has resulted in climbing bond prices. Of course, the equity market has also been up, but there is a key difference.  Bonds tend to move together when interest rates change, so when rates fall the majority of bonds in a fund rise in value.  As a result, bond trades done in a fund have a high chance of realizing a capital gain.  In the equity market you see more divergence in the returns of individual stocks.  The market may be up as a whole, but at the individual security level some stocks are up and some are down.  As a result, trading in the fund will trigger a mix of both gains and losses.

Additionally, as gains are realized in a fund, portfolio managers (PMs) typically try to offset them by looking for places to tax loss harvest.  With record low rates pushing bond prices higher and higher since 2008, there have been very few opportunities for PMs to find tax loss harvesting opportunities to offset gains.  In effect, fixed income funds have been victims of their own good fortune.

And finally, we’ve seen multiple corporate actions from financial companies this past year, affecting some corporate bond funds.  When corporates, governments, agencies and other issuers make tender offers to bondholders, bonds are often tendered (sold) back to the issuer at above-market prices, which can cause capital gains.