How can you effectively harvest tax losses in bonds

Q: How can you effectively harvest tax losses in bonds?

A: The prospect of higher interest rates scares a lot of investors as that can mean lower bond prices and the potential for losses. You can, however, take advantage of these losses to help improve the overall portfolio return.

The simplest, most effective way to take advantage of these bond losses is by harvesting them through a “tax swap.” This involves selling an individual bond to book a loss and immediately purchasing a similar, but not identical, bond at a higher yield with the proceeds of the sale. Again, the new bond cannot be identical to the original. Wash sale rules apply to the equity and fixed income markets. For a hypothetical example of a tax swap:

QuickTake

We are selling the Oakland County bond at a yield of 2.62 percent for total proceeds of $781,267.50, which captures a loss of $29,575.06. We then use the proceeds plus an additional $1,441.93 of cash to purchase a New York City issue at a yield of 2.72 percent. The additional yield along with the tax benefits of the loss we harvest give us a net benefit of $7,895. Obviously, part of this benefit is the loss we harvested. This allows us to offset future gains in the portfolio or to lower a client’s ordinary income up to $3,000.

Remember that we need to consider the loss and the yield we could be sacrificing. This is important because if the yield we give up is substantially more than our replacement yield, the value of the tax loss will be wiped out by the loss in yield.

How big of a loss do we need before we explore a tax-loss harvest? There is no “right” answer, but we like to use a loss threshold of at least $5,000 as well as 5 percent or more of the overall value of the bond. A loss of this size ensures the net benefit to the overall portfolio will be meaningful and not significantly eroded by trading costs.

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