Seizing Potential Opportunities in Bonds: Higher Yields and Tax Efficiency
Investors sometimes use bonds as a way of steadying and balancing their portfolios during turbulent economic climates. That stability came at a cost over the last decade with historically low yields bringing challenges for bond investors. However, the tide has turned with a new rate era, and bonds may still have a more prominent role to play in portfolios.
Currently, it’s more important than ever to understand how to leverage potential opportunities to enhance your portfolio and take advantage of higher rate levels.
Elevated Interest Rates Create Better Bond Environment
In 2022 the Federal Reserve embarked on the fastest interest rate hiking cycle in four decades, raising rates by 525 basis points over the 2022-2023 period. The fixed income market faced challenges due to this era of aggressive rate hikes by the Fed.
The Bloomberg US Aggregate Bond Index posted a loss of 13% in 2022 and closed out 2023 with a total return of 5%. The Fed indicated a potential pivot in interest rate policy, holding rates at elevated levels with expected cuts in 2024.
Why Do Bonds Seem to Appear So Attractive Now?
Interest rates are likely in the process of plateauing in 2024.
The two years prior set the stage for bonds to offer greater downside cushion and, as a result, a chance to improve return potential. Bonds look as attractive as we’ve seen in well over a decade, but the elevated yields might not last. Like the equity market, the fixed income market is forward looking and currently the market is looking to the Fed’s next move as rate cuts.
This makes locking in these higher-for-longer rate levels particularly appealing now and an opportunity for investors to shift from cash and money markets into bonds to lock in high yields. Investors may also consider consulting a professional for guidance on how to adjust the mix of stocks and bonds in their portfolio.
What Is the Opportunity in Bond Funds?
One of the key opportunities lies in buying bond funds that hold bonds issued before or during the recent rate hikes. These bonds are currently selling at deep discounts, reflecting the sudden rise in rates.
By purchasing these bonds at a discount, investors can benefit from the potential upside in the form of par value at maturity of the underlying holdings. Bond funds, in particular, offer tax efficiency as they carry forward losses from these discounted holdings. As bonds mature at par, the gains are reflected in the funds’ share prices, which can be taxed at long-term capital gains rates as opposed to ordinary income rates.
Investors can benefit from directly buying individual bonds at a discount to par, however the tax reporting is likely not as preferential for most. Recognition of the gain between the discount price and par value is typically treated as ordinary income and thus likely taxed at a higher rate, but remember that each individual’s tax treatment can differ.
Individual bonds may still have a prominent place in client portfolios, offering tailored approaches to cashflows and credit quality preferences. Pairing exposure to an individual bond allocation along with the opportunistic bond fund approach previously mentioned can benefit a client portfolio in many ways.
Utilizing Tax Loss Harvesting
Additional tax benefits may be available to investors who already hold bond funds that have incurred losses. Investors in these funds can take advantage of tax loss harvesting and also reap the benefit of embedded losses in bond funds previously discussed.
By selling existing fund shares at a loss, an investor would be realizing those losses which can be used to offset gains elsewhere in their portfolio or a portion of their income.
The proceeds could then be reinvested into a new bond fund or the same fund, provided that the fund remains untouched for more than 30 days in order to avoid a wash-sale.
How to Align Bond Opportunity with Your Investment Portfolio
Each investment strategy is unique and there are many factors to consider.
Coordinate with your financial advisor on the following steps to develop a strategy that fits your portfolio and financial goals:
- Assess opportunity. Assess how bonds could support or complement your investment portfolio
- Consider the big picture. Look at your full financial picture, including tax rate, your state of residence, and overall wealth and tax strategy
We’re Here to Help
For guidance on understanding if investing in bonds is right for you, or to learn how to potentially benefit from the current interest rate environment, contact your Moss Adams professional.
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