Like most things in 2022, the world of investing has been turned upside down.
For decades fixed income assets (bonds) have acted as a hedge to stocks. In times of uncertainty, when investors fled stocks, they would seek refuge in the safety of bonds. Thus, a portfolio diversified between the two asset classes has traditionally cushioned drawdowns and smoothed out returns.
Enter the year 2022 (cue the music). The first quarter of this year saw a sizable pullback in stocks, with the Nasdaq 100 plunging by as much as 21%, but instead of acting as a hedge, bonds declined as well. In less than a year the Bloomberg Aggregate Bond Index fell 9.3% from its high.* Fixed income just had its worst quarter since 1973, according to The Wall Street Journal†
Make the Most Out of a Bad Bond Situation
Instead of trying to make heads or tails of this situation and figure out whether bonds are undervalued or overvalued, why not just look at it from a tax-efficiency angle? In a taxable account, you might have the opportunity to harvest a loss in a bond fund or ETF quite early in the year, leaving you the next nine months to harvest a winner to offset it.
Perhaps, come December, you own a stock that has gone on a prolific run and you feel is overvalued. Normally, you might hesitate to sell and realize a taxable gain, but having that loss to offset it gives you flexibility. If you are not fortunate enough to book a gain later in the year, you can claim up to a $3,000 loss to offset other income on your tax return. Any amount over that can be carried forward to subsequent years. But keep reading, as there is another key to execution here.
Don’t Bail Out of Bonds Entirely
What could make 2022 more tragic than it already is? If you sold your bond fund, only to watch it rise in price the rest of the year. In such a case, you might have trouble facing yourself in the mirror. For that reason, investors executing this strategy should consider laterally transitioning the fixed income proceeds into another bond fund or ETF. That move will keep your bond exposure in the portfolio while still having realized the loss. Just be sure that when switching between products, they are dissimilar enough to avoid a “wash sale.”
A wash sale occurs when you sell a security at a loss, then buy back the same or a substantially similar security within 30 days. There is no penalty for doing so other than the inability to claim the loss. In this case, to avoid being tripped up by the wash sale rule, after selling your losing bond fund you could switch to a product with slightly different duration or credit quality and achieve similar results. Consult a tax professional or reference IRS Publication 550 to be sure your loss is not disallowed.
The Bottom Line
2022 has already been a wild ride, and we’re just getting started. But in volatile times one often finds opportunity. Harvesting a loss won’t make the world right, but it might be a small victory for the tax efficiency of your portfolio.
* Per iShares Aggregate Bond Market ETF 8/4/2021 – 4/5/2022 and QQQ 1/3/2022 – 3/14/2022
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Market Strategist/Investment Manager, Frazier Investment Management
Brian Murphy is a Market Strategist and Investment Manager at Frazier Investment Management in Southern Rhode Island. Before joining the Frazier team, he served in the US Navy for 11 years as a carrier jet pilot. Brian has experience managing several different strategies and products, including equity, fixed income, long/short portfolios and options. He believes that managing risk is the key to successful outcomes and works with clients nationwide to achieve their investing goals.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Securities and advisory services offered through LPL Financial, a registered investment advisor. Member FINRA/SIPC.