Bonds are behaving like equities. Act accordingly.

Avatar photo by Hiren B. Patel, Head of Advisor Solutions

Key Takeaways

  • In 2022, extreme volatility in fixed income markets created historic losses for bond investors 
  • But the same volatility also created significant opportunities to harvest losses within the year, in fact, intra-year bond market declines within 2022 totaled more than twice the amount of losses that could have been harvested at year end.
  • The ability to harvest, and therefore benefit from, intra-year losses can provide benefits to investors and their advisors, often at the most opportune times   

For investors there are, thankfully, relatively few years when the best thing that can be said about a year is that it’s over. And usually, it’s the stocks causing the dismay.  

From the 48% drop in the S&P during the oil-induced crash of ‘73 and ‘74, through the 37% fall in the early 2000s, to the nearly 57% drop during the Great Recession of ’07 and ’08, last year’s 19.4% hit was certainly painful and yet not awful by historical standards. Stock volatility is a known and compensated risk. Bonds on the other hand, what the… heck.   

The 16.1% drop in the Bloomberg US Aggregate Bond Index (the agg) from January to the end of October last year justifiably threw investors for a loop. The idea that a 60-40 portfolio is “set it and forget it” has taken a perfectly appropriate kick in the pants. Diversification didn’t help us when the bond market suffered the worst losses in its history at the same time equities entered bear market territory.  

Granted, the resulting higher yields and a moderating outlook for inflation have improved the outlook for bonds from this point, as evidenced by large flows into corporate bonds of late. But investors seeking safety and diversification from fixed income in 2022 were oh for two.  

However, as with the equity side of the equation, there’s an opportunity for tax loss harvesting within this drop. And as with equities, if you take a systematic approach, there’s actually opportunity within the opportunity.

Missed opportunities by Year-end 

The manual challenges of implementing tax loss harvesting strategy have limited the application and subsequent benefit of this strategy – money managers typically had to harvest infrequently and may adopt a “year-end only” approach.  

For simplicity’s sake, let’s assume a purchase in a diversified bond portfolio that tracks the agg on January 3rd, the first day of the year that the markets were open. By year end the market is, as we’re all too aware, down significantly (-12.3%) – but it recovered quite a bit from its late October low (-16.1%). Net losses are reduced by the end of the year, but so is the tax loss harvesting opportunity.   

A Year-End Only Approach Misses Opportunity

For illustrative purposes only. Source: Bloomberg. The illustration uses the performance of the Bloomberg US Aggregate Bond Index with no fees deducted for the calendar year 2022. 

Enhanced opportunity within the opportunity

Taking a systematic and automated approach to harvest fixed income losses throughout the year has historically not been viable. However, through the adoption of model delivery and broad use of bond ETFs, intra-year harvesting is now not just viable, it can be straightforward. And in years like the last one, this approach has the potential to be beneficial to investors and their advisors. Here’s why: The sum of intra-year parts can be greater than the year end whole. They certainly were in 2022.

Looking at the major bond market declines within 2022, these intra-year losses totaled -27.5% – more than twice the amount of losses that could have been harvested at year end. Last year the opportunities and benefits of this approach were significant.

Intra-Year Volatility Spurs Opportunity 

For illustrative purposes only. Source: Bloomberg. The illustration uses the performance of the Bloomberg US Aggregate Bond Index with no fees deducted for the calendar year 2022, with the following dates and declines within the year: Jan 3 to Feb 16 (-3.3%), March 1 to May 6 (-8.0%), May 31 to June 14 (-4.1%), Aug 1 to Oct 21 (-9.8%) and Dec 15 to Dec 30 (-2.3%.) Specific tax loss harvesting benefits will be impacted by purchase price(s) as well as the performance and timing of the investments subsequently purchased after a harvesting event.

Admittedly this is a simplified illustration of tax loss harvesting at the fund/portfolio level only. In our example there’s one tax lot purchased at the beginning of the year, and the market peaks and troughs are identified with the benefit of hindsight – but the thesis still holds. That is, the easier it is to tax loss harvest the more often it can be done. And the more often it’s done, the larger the opportunity for harvesting can be.

Our thesis holds in up years too. When calendar year returns are positive for bond or equity markets, it certainly doesn’t mean that there weren’t significant drawdowns in between those end points. On the stock side, the growth of direct indexing facilitates systematic tax loss harvesting at the security level and so adds an additional layer of opportunity. There’s more on that in our December blog on equity performance dispersion.

Hopefully we won’t see bond market declines like this for some time, but who knows. With assets flowing into corporate bonds and the need for income and portfolio stability certainly not dissipating, it’s perhaps better to be prepared and positioned accordingly.

Systematic, Straightforward Implementation

Looking at tax loss harvesting as simply a year end activity is now a missed opportunity for advisors to add value. Whether with bond or equity portfolios, what was a complex and cumbersome manual process is no longer. With 55ip, a systematic, automated approach is straightforward. Losses can be easily harvested throughout the year, allowing advisors to improve investment outcomes – and client relationships – in differing market environments, but especially at times like this when the ability to add value is needed most.

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