Interest rates rose sharply at the end of September as the US 10-year Treasury yield spiked 31 basis points from 1.30% to 1.61% today.1 As a result, investors likely felt a twinge of pain from their fixed income holdings.
While the increase in rates has put downward pressure on bond prices across many sectors, all is not lost.
The silver lining? This weakness has created tax-loss harvesting opportunities for fixed income positions in a year when most equity exposures have rallied — except for Chinese equities.2
Our Process to Find Tax-Loss Harvesting Opportunities
Tax-loss harvesting is the act of selling a security in a taxable account at a loss and using the loss to offset realized taxable gains to help reduce taxes.
Before analyzing where the opportunities for tax-loss harvesting reside, it is important to distinguish between a security’s total return and price return. Total return considers all income received from a security throughout the investor’s holding period (dividends, interest, etc.). In the case of tax-loss harvesting, price return is what matters. An investor’s capital gains liability (or loss) is based on the purchase price and the sale price, without any regard for dividend or interest payments received.
For this study, we calculated the year-to-date price change for every US-listed exchange traded fund (ETF) through October 11th (approx. 2,800 funds). We then set a price loss threshold of 2% to flag funds that could potentially be tax-loss harvesting candidates. Once we identified all the funds that met this threshold, we segmented them based on their Morningstar categories and aggregated the data in order to identify trends.
Most Tax-Loss Harvesting Opportunities Are in Bonds
Because the income received is such a large component of a bond’s return, this asset class often can be overlooked when tax-loss harvesting. Investors often view a bond exposure as having generated positive total return due to the income received, when the price return has a loss.
The sharp rise in rates has pushed approximately four out of every five fixed income ETFs into year-to-date price losses. And approximately one in every three funds currently has a price loss of more than 2%3 (see Figure 1). For bond investors, this presents a plethora of positions that could be harvested this autumn.
Figure 1: Percent of Fixed Income ETFs in Price Losses YTD
Our research shows five key areas where investors may potentially harvest losses: Intermediate Core, Corporate Bonds, Intermediate Government, Long Government, and Intermediate Core-Plus. As Figure 2 shows, 87 funds across these five segments — with total net assets of more than $470 billion — have experienced price losses greater than 2%.4
Notably, while most categories have average year-to-date price losses in the 2.5% to 3.5% range, Long Government funds have suffered roughly triple the losses due to their longer duration, and thus greater sensitivity to changes in interest rates.5
Taking the analysis one step further, we sought to identify specific tax-loss harvesting opportunities within each of the five fixed income segments.
To do this, we used both the severity of year-to-date losses and fund flows as guideposts to determine the most actionable ideas. Fund flows can help us identify which new investors in 2021 may currently be at a loss. Details and SPDR ETFs to consider for potential “tax swaps” are shown below.
Tax swaps are similar but not identical securities where proceeds from harvested positions are later invested. The “Harvest to Swap or Refine Exposures” section of this blog provides more detail on swaps and the Internal Revenue Service’s Wash-Sale Rule.
Figure 2: Fixed Income Opportunities at a Glance
|Morningstar Category||Average YTD Price Loss (%)||Number of Funds with YTD Price Loss > 2%||Total AUM of Funds with YTD Price Loss > 2% ($M)||YTD Flows ($M)||SPDR® ETFs to Consider as Tax Swaps or Replacements|
|Intermediate Core||-3.33%||22||$210,323||$27,729||SPDR® Portfolio Aggregate Bond ETF (SPAB)|
Source: Morningstar, Bloomberg Finance L.P., as of 10/11/2021. Calculations by SPDR Americas Research. Past performance is not an indicator of future performance.
Don’t Stop at ETFs for Tax-Loss Opportunities
Comparing ETFs to ETFs for tax-loss opportunities is a natural process, as many of the strategies are based on similar indices and, therefore, offer similar macroeconomic exposures. Yet, this doesn’t mean that investors should focus only on ETFs. Given that most bond sectors are down this year, mutual funds covering fixed income asset classes are also impacted.
Fixed income mutual funds, as shown below, have considerable losses as well. In fact, across the same five categories, more than 50% of the funds are currently at a loss. Notably, some of these funds are actively managed and may be outperforming their benchmark even if at a loss.
Figure 3: Mutual Fund Tax-Loss Opportunities
Yet, when screening for just active funds with losses that are also underperforming their prospectus benchmark, there are considerable opportunities ($232 billion worth of assets)6 not only to harvest a loss but to replace a lagging manager, as shown above in the last column.
And importantly, because mutual funds are higher fee instruments than ETFs there also is an opportunity to lower fees. The median fixed income ETF fee is 0.29%, but some have an expense ratio as low as 0.03%. Comparatively, the median fee for all fixed income mutual funds, and not just the categories shown above, is 0.62%.7
Don’t Forget About Stocks
As previously mentioned, most equity exposures have rallied in 2021. The S&P 500®, MSCI EAFE, and MSCI ACWI have climbed between 6% and 16% year to date, while emerging market equities have been roughly flat.8 Chinese stocks are the main exception. After climbing nearly 20% through mid-February, prices of Chinese stocks tumbled and have yet to recover.9 In fact, in Q3, the Evergrande scandal rattled equity markets and further contributed to the nation’s current year-to-date price loss of 14%.10
As a result of this turmoil, tax-loss harvesting opportunities in China-region equity ETFs are plentiful. ETFs in this category have an average year-to-date price loss of 4.5%,11 however much is hidden in the average. Of the 45 ETFs analyzed, 31 have experienced price losses (69%).12 And of those 31 ETFs, 16 (36%) have price losses of 10% or more year to date.13
Figure 4: Price Return Distribution of China-region ETFs
Harvest to Swap or Refine Exposures
Traditionally, after selling the losing position, investors have used a “tax swap” — a similar but not identical security — as a placeholder to maintain exposure to the asset class for 30 days. After 30 days, they choose whether to switch back to the original holding.
Keep in mind that if the new investment appreciates and you sell it within a year, those gains will be taxed at the short-term capital gains tax rate, which is higher than the long-term rate. For that reason, it may be advantageous to choose a swap that could become a long-term holding.
Answering these three questions can help you decide whether to use a temporary swap or to employ a new strategy:
To guide decision-making, please contact your SPDR ETF Regional Consultant to discuss how we can help. This service offers portfolio level insights by looking through every fund at the individual security level. Examples of insights gained from this analysis include: fundamental characteristics; sector, country, credit rating, and duration exposures; stress tests; and more. Using this information can aid investors to make better informed portfolio construction decisions.
Whether you choose a swap or more permanent replacement, remember that ETFs generally have lower expense ratios than mutual funds do.14 Also, by nature of their unique create and redeem functions, ETFs are inherently more tax-efficient vehicles than mutual funds are as they typically do not distribute capital gains as often as mutual funds do.
Tax-Loss Harvesting Rules
In taxable accounts, when you sell a position that has lost value, you can use the loss to offset capital gains that result from selling securities at a profit during the year. Your booked losses can also offset funds’ annual capital gain distributions.
At year-end, if your capital losses exceed your gains (or if you don’t have any gains), your losses can offset up to $3,000 in non-investment income, even though that is often taxed at a higher rate than capital gains are. Losses greater than $3,000 carry forward and can be used to offset capital gains and ordinary income over your lifetime.
Importantly, when reinvesting the sale proceeds, you must abide by the Internal Revenue Service’s Wash-Sale Rule, which prohibits claiming a loss on the sale of an investment if the same or “substantially identical” investment is purchased either 30 days before or after the sale date.
While investors look for portfolio losses in the fourth quarter, tax-loss harvesting is a strategy that can be implemented throughout the year. In fact, if you harvest losses only at yearend, investments that were down early in the year could have bounced back into positive territory — resulting in missed opportunities to sell losers and book losses to offset realized gains.
1Bloomberg Finance L.P. as of October 8, 2021.
2Bloomberg Finance L.P. as of October 8, 2021. The year-to-date price change of the S&P 500, MSCI EAFE, and MSCI ACWI is 16.11%, 10.72% and 5.94%, respectively. The year-to-date price change of the MSCI China is -14.70%. Past performance is not an indicator of future performance.
3Morningstar, Bloomberg Finance L.P., as of 10/11/2021. Calculations by SPDR Americas Research. Past performance is not an indicator of future performance.
4SPDR Americas Research, Morningstar, Bloomberg Finance L.P., as of 10/11/2021. Past performance is not an indicator of future performance.
5Morningstar, Bloomberg Finance L.P., as of 10/11/2021. Calculations by SPDR Americas Research. Past performance is not an indicator of future performance.
6Morningstar, Bloomberg Finance L.P., as of 10/11/2021. Calculations by SPDR Americas Research.
7Morningstar, as of 10/11/2021. Calculations by SPDR Americas Research. The median net expense ratio of US-Listed ETFs is 0.50%. The median net expense ratio of US domiciled mutual funds (oldest share class) is 0.82%.
8Bloomberg Finance L.P. as of October 11, 2021. Emerging market equities = MSCI Emerging Markets Index. Past performance is not an indicator of future performance.
9Bloomberg Finance L.P. as of October 11, 2021. Chinese stocks = MSCI China Index. Past performance is not an indicator of future performance.
10Bloomberg Finance L.P. as of October 11, 2021. Past performance is not an indicator of future performance.
11Morningstar, Bloomberg Finance L.P., as of 10/11/2021. Calculations by SPDR Americas Research. Past performance is not an indicator of future performance.
12Morningstar, Bloomberg Finance L.P., as of 10/11/2021. Calculations by SPDR Americas Research. Past performance is not an indicator of future performance.
13Morningstar, Bloomberg Finance L.P., as of 10/11/2021. Calculations by SPDR Americas Research. Past performance is not an indicator of future performance.
14 Morningstar, as of 10/11/2021. Calculations by SPDR Americas Research. The median net expense ratio of US-Listed ETFs is 0.50%. The median net expense ratio of US domiciled mutual funds (oldest share class) is 0.82%.
S&P 500 Index A market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria to be included in the index.
MSCI ACWI Index A stock index designed to track broad global equity-market performance, All Country World Index (ACWI). Maintained by Morgan Stanley Capital International (MSCI), the index is comprised of the stocks of about 3,000 companies from 23 developed countries and 26 emerging markets.
MSCI AEFE Index Designed to represent the performance of large and mid-cap securities across 21 developed markets, including countries in Europe, Australasia and the Far East, excluding the U.S. and Canada. Europe, Australasia (the region made up of Australia and New Zealand), and the Far East.
Important Risk Information
The views expressed in this material are the views of Matthew Bartolini and Martin Dunn through the period ended October 20, 2021 and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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Investing involves risk included the risk of loss of principal.
Diversification does not ensure a profit or guarantee against loss.
Equity securities may fluctuate in value in response to the activities of individual companies and general market and economic conditions.
Non-diversified funds that focus on a relatively small number of securities tend to be more volatile than diversified funds and the market as a whole.
Passively managed funds hold a range of securities that, in the aggregate, approximates the full Index in terms of key risk factors and other characteristics. This may cause the fund to experience tracking errors relative to performance of the index.
While the shares of ETFs are tradable on secondary markets, they may not readily trade in all market conditions and may trade at significant discounts in periods of market stress.
Bonds generally present less short-term risk and volatility than stocks, but contain interest rate risk (as interest rates rise, bond prices usually fall); issuer default risk; issuer credit risk; liquidity risk; and inflation risk. These effects are usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Investments in mortgage securities are subject to prepayment risk, which can limit the potential for gain during a declining interest rate environment and increase the potential for loss in a rising interest rate environment. The mortgage industry can also be significantly affected by regulatory changes, interest rate movements, home mortgage demand, refinancing activity, and residential delinquency trends.
Investing in high yield fixed income securities, otherwise known as “junk bonds”, is considered speculative and involves greater risk of loss of principal and interest than investing in investment grade fixed income securities. These Lower-quality debt securities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer.
The funds presented herein have different investment objectives, costs and expenses. Each fund is managed by a different investment firm, and the performance of each fund will necessarily depend on the ability of their respective managers to select portfolio investments. These differences, among others, may result in significant disparity in the funds’ portfolio assets and performance. For further information on the funds, please review their respective prospectuses.