Market Overview

Interest Rate Hike Will Maul Bond Investors: How You Can Heal Wounds in Taxable Portfolios


By Ken Carbaugh


  • Fed Chairwoman Janet Yellen said the central bank may raise interest rates earlier -- and perhaps faster -- than planned “if the labor market continues to improve more quickly than anticipated.”

  • Rising interest rates goes hand in hand with falling bond prices and loss of principal

  • Investors can take advantage of losses in taxable accounts

  • Tax efficiency is more important than ever after the 2013 tax hikes from the fiscal cliff deal and Obamacare (Affordable Care Act)

The ultra-low interest rates that we’ve experienced since late 2008 will eventually have to rise back to normal. The consensus expects the benchmark rate to spike to 1% by the end of next year. Given that bonds yields and prices move in opposite directions, investors in long-dated 10- to 30-year bonds, will be mauled.  

The longer a bond has until maturity, the more sensitive it is to interest rates movements. Last year when yields on 20-year Treasury bonds rose 1.09% , iShares 20+ Year Treasury Bond ETF (TLT) dropped 13%, according to Morningstar. Vanguard Extended Duration Treasury Index ETF (EDV) crashed 20% while PIMCO 25+ Year Zero Coupon U.S. Treasury Index ETF (ZROZ) plunged 21% -- painful drops for risk-averse investors relying on yield income.  Thankfully, they’ve rebounded 20% and 23%, respectively, so far this year, as of July 16, as 20-year Treasury rates declined by 0.6%.

Bonds yields and interest rates move in opposite directions

But the pain is expected to return as rates rise and bond prices fall. Here’s one way you can treat the anticipated wounds to your taxable portfolios. In industry parlance, it’s called a tax swap. You simply sell one bond to harvest a tax loss and then buy another one of similar maturity. In a taxable portfolio, realizing losses can reduce your tax bill in several ways:

1. Losses in asset can be used to offset realized capital gains on another investment.

2. They can be carried forward to offset future realized capital gains.

3. They can be used to reduce ordinary income in current and future tax years by a maximum of $3,000 per year.

Because of the higher income-tax rates that went into effect last year because of the fiscal cliff deal and Obamacare (Affordable Care Act), tax efficiency is more important than ever.

Tax Swapping

Say you sold a double-A minus-rated bond with a 5% coupon that matures in May 2028, callable in May 2018.  And say you realized a loss of $7,744 and had total proceeds of $224,718. Then you buy a AAA-rated municipal bond with a 5% coupon that matures in October 2028, callable October 2019, for a total of $225,939. The transaction costs you $1,200.

Screen Shot 2014-07-16 at 3.10.02 PM.pngHow did this bond swap benefit you? In this example, you increased the credit quality, along with the call protection and extended the maturity by five months. If you had no realized gains for the year you could offset ordinary income by $3,000. The remaining $4,744 can be carried forward to future years.

As we all know too well, the IRS likes to put rules and regulations in place so we don’t do tax swaps willy-nilly.

In doing these bond swaps, you need to be attentive to what’s considered substantially identical and the Internal Revenue Service’s wash sale rule. The wash sale rule basically states that if you have a losing position, sell it, and then buy back the same -- or substantially identical -- asset within 30 days, you cannot count that as a tax loss.

The term “substantially identical” is a fuzzy rule under the Internal Revenue Code (IRC) § 1091, hence the tax courts are hearing several cases related to bond sales.

For example, according to Revenue Ruling 1960-195, the new issue Richmond-Petersburg Turnpike Authority 3.45% Revenue Bonds and the additional issue Richmond-Petersburg Turnpike Authority 4.5% Revenue Bonds were not deemed “substantially identical” securities. These bonds were issued by the same issuer at different times with the same maturity and a 1.05% difference in coupon rates. But they were not considered substantially identical.

Please keep in mind that everyone’s situation is different and you should consult your or a tax expert to make sure this makes sense for you.

Kenneth J. Carbaugh is a portfolio manager at Liberty Capital Management in Birmingham, Mich. He has over 13 years of investment experience, most recently, at Comerica Asset Management where he traded individual bond portfolios totaling over $500 million.  Prior to that he was Director of Portfolio Management at Portfolio Solutions, LLC where he managed $250 million of municipal bonds and $1.2 billion of equity and ETF portfolios.  Ken has a BBA in Finance from Walsh College and is currently working toward his MBA at the University of Detroit Mercy.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

Posted-In: Bonds


Related Articles

View Comments and Join the Discussion!