Bond investors should consider the current status of the fixed-income environment and look ways to incorporate ETFs as a means to effectively harvest potential losses.
On the recent webcast (available On Demand for CE Credit), Tax Loss Harvesting: What You Need to Know, Matthew Bartolini, Vice President and Head of SPDR Americas Research at State Street Global Advisors, illustrated a current fixed-income market environment where the yield curve has flattened.
The Federal Reserve is slowly lifting the short end of the curve through interest rates hikes, and the markets are anticipating at least two more hikes before the year ends. On the long end of the curve, 10-year yields are nearing 3% again on the heels of strong second quarter GDP growth and increasing U.S. Treasury supply. However, the lack of confidence and growing concerns have depressed yields on the long-end of the curve.
Looking ahead, Bartolini argued that the flattening of the yield curve may continue through the end of the year as the Fed funds projections could rise to 2.25% if there is one more hike or 2.5% if there are two more hikes based on beta sensitivity to the U.S. 2-year yield.
In the credit market, the recent dash-for-cash led to credit spreads tightening and lower-rated segments of the market outperforming. Investment-grade corporate credit has exhibited negative returns this year while speculative-grade debt outperformed. Bartolini noted that the spread tightening in Health Care and Communications contributed the most to the positive performance.
Emerging market local debt has also been pummeled with currencies playing a key factor in the driver of returns and risks of emerging debt.
Given the current market environment, many have turned to short-duration exposures as a source of attractive income generation while also limiting downside risks from further interest rate hikes. Bartolini advised investors that they may be well served to focus on floating rates that have the most optimal yield per unit of duration with the Fed continuing to hike rates.
Overall, Bartolini painted a picture of further weakness in the fixed-income market, projecting prices to continue to fall as rate hikes on the horizon may continue.
Due to the underperformance in the fixed-income space, bond investors may have experienced a negative return. However, investors may potentially enhance their after-tax returns if they engage in tax-loss harvesting. Tax-loss harvesting allows investors to “lock in” losses by selling securities that have depreciated in price since purchasing the asset. By using these losses, one may offset capital gains, potentially diminishing an investor’s tax liability and enhancing after-tax returns.
Bartolini explained that if the capital losses exceed a portfolio’s capital gains, the net loss can be used to offset up to $3,000 of the current year’s ordinary taxable income. If the annual net loss is more than $3,000, the excess can be carried forward to offset gains and ordinary income in future tax years.
Blaine Docker, Chief Operating Officer at Main Management, pointed out that there are 2 types of gains and losses: short-term and long-term. Short-term capital gains and losses include the sale of investments owned for 1 year or less. Long-term gains and losses are realized after selling investments held longer than 1 year. The difference between the two is the rate of taxation.
Short-term gains are taxed at the marginal tax rate on ordinary income of up to 37%. For those subject to the net investment income tax, the effective rate can be has high as 40.8%. Long-term capital gains rates, on the other hand, are significantly lower at the top bracket at 23.8% including NIIT for high earners. This is important to know because short and long-term losses must be used first to offset gains of the same type, and focusing on short-term losses can be beneficial for high-income investors.
Joshua Jenkins, Portfolio Manager for CLS Investments, also noted that based on a sampling of their portfolios, about 80% of fixed income exposure has an unrealized loss spread across virtually all sectors, with tax lots at a loss which were acquired each year going back to 2013. However, Jenkins added that the interest payments were often enough to overcome the price declines from rising rates, so these types of investments are not completely without merit in a total return standpoint.
As investors reassess their fixed-income portfolios to potentially engage in a tax-loss harvesting strategy, Bartolini argued one may look at ETFs to lower costs or rotate into a potentially more beneficial sector.
For example, the SPDR Portfolio Intermediate Term Corporate Bond ETF (NYSEArca: SPIB) and SPDR Portfolio Aggregate Bond ETF (NYSEArca: SPAB) provide intermediate-term bond exposure.
The SPDR Portfolio Short Term Corporate Bond ETF (NYSEArca: SPSB) and SPDR Bloomberg Barclays Investment Grade Floating Rate Note ETF (NYSEArca: FLRN) can be used for short-term bond exposure.
For high-yield or speculative-grade bond exposure, the SPDR Bloomberg Barclays High Yield Bd ETF (NYSEArca: JNK) has been among the go-to options for broad junk bond investments. Additionally, the SPDR Barclays Short Term High Yield Bond ETF (NYSEArca: SJNK) helps investors access a lower duration avenue to high-yield corporates without a significant sacrifice in terms of yield. The actively managed SPDR Blackstone/GSO Senior Loan ETF (NYSEArca: SRLN) covers senior secured floating-rate bank loans that are seen as a way for fixed-income investors to maintain yield generation while hedging rate risk
Financial advisors who are interested in learning more about the fixed-income market and tax-loss harvesting can watch the webcast here on demand.