It is the season of tax swaps. With the large swings in the equity markets, many investors find themselves in the enviable position of dealing with market gains leading some to seek the shelter of utilizing portfolio losses to offset these gains. Frequent questions arise concerning how municipal bonds can be utilized to relieve some of an investor’s tax burden or in some cases how replacement bonds may fit the overall portfolio strategy as more and more issues are being offered at discounts.
In most circumstances, market discounts are bonds priced below par. The difference between the redemption price (typically par) and the purchase price reflects the market discount. Market discounts are taxed in the year of sale or redemption at the investor’s ordinary income tax rate. The price appreciation gained during the holding period is the amount being taxed, not the interest earned. In a tax-exempt municipal bond, the interest earned is federally tax-exempt.
The IRS allows for very small, or de minimis, amounts to be taxed as a capital gain (which is typically a lower tax rate versus ordinary income). The de minimis amount is an amount less than 0.25% of the face value of the bond times the number of complete years between the acquisition date and maturity date.
Original Issue Discounts (OID) (the difference between the original issue price and face value of a bond) are different from Market Discounts. A recognizable example would be zero coupon bonds. The original discount on the zero coupon issue represents the interest earned and therefore is federally tax-exempt just like the interest earned on a coupon bond. If the discount exceeds the OID, that difference would be a market discount.
As we approach year’s end, timing is good to seek out one of the few tax shelters left for investors. Contact your advisor if you feel you can benefit from a tax loss swap. Be sure to consult your tax advisor to ensure a proper understanding of any tax consequences as Raymond James is not a tax expert and does not provide tax advice.
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.
November 5, 2018
Yields are climbing… inch by inch. As anticipated, long end rates are outpaced by the short end yield increases prompted primarily by Fed Funds rate hikes. Since the start of year, modest increases can be seen across the Treasury yield curve:
It is not unusual to see investors position for the future, after all, this is the tactical approach common for equity investing. Buy low, sell high. However, the process for fixed income allocation merits its own distinct method and altered thinking process. Many investors utilize fixed income as a beneficial balancing tool. In other words, bonds primary purpose is DIFFERENT than other assets. It is to protect principal while delivering a known income and cash flow, not a tool to gain growth through future price appreciation. The goals of these various asset classes are typically very different yet not always treated as such.
Tactical assessment warns investors that as interest rates rise, bond prices will fall. This is a basic mathematical fact associated with a fixed coupon bond. However, the consequence to heeding this warning, “don’t buy bonds in a rising interest rate environment because their prices will go down”, may produce dismay to long term investment plans. For investors informed on the distinct goal differences between asset classes, isolating only on price may alter a portfolio’s balance away from an ideal allocation. Keep in mind that as interest rates rise (or fall), bonds held to maturity will see absolutely no change to the income or cash flow they produce and face value will be returned upon maturity, regardless of any price fluctuations. Moreover, increasing yields will benefit the net portfolio yield as cash flows and rollovers are reinvested in the increased yield environment.” Different asset classes, different goals… different mindset!
The benefits of this slow rising interest rate environment will deliberately benefit the portfolio’s fixed income allocation. The Treasury curve continues to trade in a very tight range but in a range that has slightly elevated yields versus those experienced at the start of the year. The following graph may help sum up the story:
Don’t allow short-range moments in the market to dictate long term investment planning. In the long run, higher yields will mostly help the fixed income allocation by increasing the predictable income and continue balancing the growth asset allocation.
October 29, 2018
A recent fashionable endorsement for dealing with low interest rates has been the comparison of equity dividend yields versus Treasury yields. Since the great recession of 2008-2009, there have been 2 brief periods when the S&P 500 Index dividend yield on the S&P 500 Index was actually higher than the 10 year Treasury yields, thus the advent of the proposed potentially unwise asset substitution.
Why might such an asset class substitution be ill-advised? For beginners, stocks and bonds support very different portfolio purposes. Stocks provide the mainstay for growth. Although they often possess higher risk, they may also provide a course for abundant growth of wealth. Conversely, bonds may not provide as much potential for growth, however they often have less downside risk and deliver a fixed amount of income and predictable cash flow. Often, bonds primary goal is to maintain already acquired investor wealth. Beyond a comparison of yields of the different asset types, investors should also be mindful of the fact that dividends are only paid when, if and as declared by a corporation’s board of directors. Bond interest, on the other hand, is an obligation of the corporation.
Comparisons often contrast the S&P 500 Index to a Treasury Index as graphed above. The two indices can be tracked back to 1980 and the only time when they are remotely close is between 2008 and 2017. In other words, the above graph is a worst case scenario for bonds. Even as the two indices get close or cross over, the short term event should not deter from an investor’s long-term investment plan and asset allocation balance. A more realistic comparison may be corporate yields versus equity dividend yields. After all, many of our fixed income investors use spread products such as CDs, corporate bonds and municipal bonds for their portfolio’s fixed income asset allocations. These products may be a more appropriate representation of fixed income allocation designed to balance the growth assets such as equities and provide a means of wealth preservation, income and cash flow. The following chart compares the S&P 500 dividend yields to corporate yields as opposed to Treasury yields:
As the chart illustrates, dividend stocks are not a comparable match or replacement of fixed income for the income producing and wealth preservation allocation of portfolio assets. As we often state, appropriate asset allocation is the foundation for optimizing balance, efficiency and protection for your investment portfolio.