The Dow Jones Industrial Average is up roughly 17.8% year-to-date. The S&P 500 is up around 15.5% year-to-date. According to the US House Price Index, residential property prices have climbed nearly significantly over the last year. Are you feeling wealthy yet? Is it time to take some of the newly accumulated capital off the table? As we approach the year’s end, timing may just be right for tax loss swaps. Tax loss swaps typically work better in a rising interest rate environment thus recent years have not presented ample opportunity; however, the elevated equity and housing markets along with this year’s short-term rise in interest rates may warrant a look at tax loss swaps this year.
In general, tax loss swaps harvest losses as a means to offset gains taken on other securities. Under the wash sale rules, the replacement bond cannot be exactly the same if purchased within 30 days; however, with bonds, the maturity, call protection, yield and credit quality could remain virtually the same with a different obligor, thus not disrupting the overall portfolio strategy. Conversely, the tax losses may be gathered to institute changes: improve yield, change credit quality or take advantage of current relative values or sectors. The approach offers a high degree of flexibility in the process of using capital losses to offset capital gains.
As time passes, bonds age, rolling down the curve as they move closer to their maturity dates. The Fed has slowly begun to push short-term interest rates up, thus potentially creating lower prices on some of the aged, shorter term positions. At the same time, the equity portfolio has grown, perhaps even creating a mis-balance between strategic asset allocation of equity and fixed income percent holdings. A tax loss swap could allow investors to take some of their earnings out of the market, offset the taxed profits, rebalance asset allocation appropriately and position the reinvestments to optimize their specific needs.
Other special situations, such as changes in credit quality (i.e. Puerto Rico), may present loss options that if liquidated would create losses and an opportunity to improve the portfolio’s credit quality. Should capital losses exceed capital gains, the losses are permitted to be carried forward and used in subsequent years. Also, up to $3,000 can be used to reduce current taxable income. Conditions, although not perfect, may have shifted enough and provide potential spot opportunities that haven’t existed for years.
Please always consult your tax professionals to guide your decision process with any tax manners.
To learn more about the risks and rewards of investing in fixed income, please access the Securities Industry and Financial Markets Association’s “Learn More” section of investinginbonds.com, FINRA’s “Smart Bond Investing” section of finra.org, and the Municipal Securities Rulemaking Board’s (MSRB) Electronic Municipal Market Access System (EMMA) “Education Center” section of emma.msrb.org.
The author of this material is a Trader in the Fixed Income Department of Raymond James & Associates (RJA), and is not an Analyst. Any opinions expressed may differ from opinions expressed by other departments of RJA, including our Equity Research Department, and are subject to change without notice. The data and information contained herein was obtained from sources considered to be reliable, but RJA does not guarantee its accuracy and/or completeness. Neither the information nor any opinions expressed constitute a solicitation for the purchase or sale of any security referred to herein. This material may include analysis of sectors, securities and/or derivatives that RJA may have positions, long or short, held proprietarily. RJA or its affiliates may execute transactions which may not be consistent with the report’s conclusions. RJA may also have performed investment banking services for the issuers of such securities. Investors should discuss the risks inherent in bonds with their Raymond James Financial Advisor. Risks include, but are not limited to, changes in interest rates, liquidity, credit quality, volatility, and duration. Past performance is no assurance of future results.