Bond rally dims hopes for US tax perks but long-term losses remain

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The November bond market rally has come as a relief for many investors but weak debt markets over the previous two years have still left many nursing steep losses that can be used to lower tax bills.

US rules allow investors who sell poorly performing securities to offset the realised losses against taxes owed on other capital gains. The process, known as tax loss harvesting, is often blamed for a lot of late-year selling in beaten-down assets.

The Bloomberg US Aggregate Bond index is down more than 10 per cent since 2021. In contrast, the S&P 500 is nearly back to where the equity index was at the start of 2022, when it suffered its worst year since the 2008 financial crisis.

Investors who harvest losses can reinvest in similar, but not identical, investment strategies. In recent years, this has increasingly involved mutual fund investors reallocating to exchange traded funds, which also hold stocks and bonds but enjoy preferential tax treatment in the US.

While the amount of “harvesting” depends on individual investors’ portfolios, investment advisers said the new interest in bonds as a tool for offsetting gains marked a big shift in thinking among investors.

“Most investors typically don’t think of fixed income as an area to harvest,” said Allison Bonds Mazza, head of private wealth management and independent wealth management with State Street Global Advisors. “They typically think of equities as where they should look to tax loss harvest. But this year, fixed income is the first place investors should look.”

Like their far bigger rivals, ETFs hold securities but can be traded like stocks and enjoy tax advantages over mutual funds in the US besides those gleaned from harvesting losses.

Investors who sell their existing holdings may find it easier to reinvest in ETFs to avoid “wash sale” complications, where the IRS bans investors from selling investments to realise a loss and then buying back a substantially identical security within 30 days.

While ETFs have long been associated with passive strategies, issuers have steadily pumped out new active fixed income ETFs in recent years. Asset managers have launched 58 active fixed income ETFs so far in 2023, with only 26 mutual funds joining them. They had both roughly kept pace in 2022 and 2021, according to data from Morningstar.

“People who were sitting on gains for years now are seeing the merits of making a change,” said Todd Rosenbluth, head of research at VettaFi, a consultancy. “We just have more choices that can fit the bill [and] you can keep your risk-on bet, and save money, and get the tax loss harvesting benefits.”