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Some good may emerge from the price declines in fixed income holdings: You can trim next year’s tax bill and refresh your bond exposure as 2023 winds down. Tax loss harvesting is a staple of year-end planning. This move involves selling off positions in your portfolio that have suffered price declines and using those losses to offset taxable capital gains elsewhere. In the event your losses exceed your capital gains, you may apply up to $3,000 of these losses to offset ordinary income on your federal tax return and carry over the remainder to future years. Bonds are ripe for tax loss harvesting in the wake of the Federal Reserve’s rate-hiking cycle. When bond yields rise, their prices fall. Long-dated issues and the funds that hold them have felt the pain most keenly from tighter policy. That’s because bonds with longer maturities have greater duration – that is, their prices are more sensitive to fluctuations in rates. Consider that the longer-dated iShares 20+ Year Treasury Bond ETF (TLT) has a year-to-date total return of about -7.3%, while the shorter-term iShares Core US Aggregate Bond ETF (AGG) has a total return of roughly 0.7% in 2023, according to Morningstar. “As the Fed has raised rates aggressively, that has had a negative impact on bonds in those funds,” said Kristy Akullian, senior iShares investment strategist at BlackRock. “Tax loss harvesting is a silver lining for some of the pain they’ve been feeling the last couple of years.” Bonds and the wash sale rule To benefit from tax loss harvesting, investors must avoid violating the wash sale rule . You incur a wash sale when you sell an asset at a loss and within 30 days before or after the transaction, you buy a “substantially identical” security. Do that, and the Internal Revenue Service can disallow the loss altogether. That means investors should be mindful of how they redeploy the proceeds from the sale of a losing position and take care to pick an asset that’s sufficiently different. “Looking at changes in duration, going from intermediate to short term, or going from municipals to corporate would all put you on very firm ground,” said Jeffrey Levine, certified public accountant and chief planning officer at Buckingham Strategic Wealth in St. Louis. For people shopping for individual bonds rather than funds, there could be some nuance. “On the corporate side, most people feel if you buy a bond of a different corporation, you’re probably OK,” Levine added. “For munis, this is where people look for yield and duration changes to be a little more secure.” Revisit your fixed-income sleeve Financial advisors who have been harvesting losses lately are also taking the opportunity to rebalance portfolios and fine-tune fixed income holdings. “If they are comfortable with interest rate risk, we take on more duration in the range of seven to eight years,” said Jordan Naffa, certified financial planner at Arista Wealth Management in Las Vegas. Adding bond duration is a way to prepare portfolios for an environment when interest rates decline. In a falling rate environment, the prices of the underlying bonds in a fund will rise. Indeed, Naffa has replaced some exposure to the Vanguard Short-Term Treasury ETF (VGSH) with the Vanguard Intermediate-Term Treasury ETF (VGIT) . VGSH has a 30-day SEC yield of 5.13%, while VGIT offers a 30-day SEC yield of 4.77%. Both funds have an expense ratio of 0.04%. The Vanguard Intermediate-Term Corporate Bond ETF (VCIT) has also been a popular way to raise duration exposure, he said. The fund has a 30-day SEC yield of 6.14% and an expense ratio of 0.04%. For investors with individual bonds, now might be a good time to look at what may be worth replacing at a similar or higher coupon at a better price. That’s the tack Lisa A.K Kirchenbauer, CFP and founder of Omega Wealth Management in Arlington, Va., is assessing. “If we are selling out of a bond ladder, buying back in and extending duration, it’s an opportunity,” she said. She buys back in after the wash sale period has passed to ensure the client can take the loss on their taxes. Laddering bonds involves buying a portfolio of individual issues that mature on different dates. As the near-dated bonds mature, proceeds from maturing issues can be reinvested in longer-dated bonds. Finally, tax loss harvesting can also present an opportunity to do a gut check on risks and fees: Think about the goal the replacement asset is trying to achieve, the credit quality and the expense ratio. “At the end of the day, if you sell this very conservative bond fund but buy a junk bond, you’re taking risk you may not have wanted to,” said Naffa.
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