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The bond market selloff has many investors licking their wounds, but it could also be a good time to take your losses as a tax advantage. With the 10-year treasury yield seeing a massive single-day spike on Wednesday, hitting its highest level since 2007, and bond prices continuing to fall, investors who bought bond mutual funds or ETFs when yields were lower may be sitting on unrealized losses within their portfolio. Investors often wait until December to tax-loss harvest — or sell investments at a loss and use their losses to offset gains in other investments. But you don't have to wait. The very thing hurting your bond ETF today — higher yields — can potentially give you both a tax asset and an opportunity to reinvest at a higher yield. "Tax-loss harvesting is often treated as a year-end exercise. But markets don't follow the calendar," senior portfolio managers Joseph Gotelli and Jason Greenblath wrote in a recent report for American Century Investments. "Today's fixed-income landscape offers compelling potential opportunities to harvest losses, manage tax liabilities and improve yield and tax efficiency." Taking a look at this tax strategy more often has been recommended in recent years amid persistent bond underperformance. "It's sensible to do tax-loss harvesting in client portfolios on a regular basis when opportunities arise," Vanguard Group wrote in an ETF industry perspective in the fourth quarter of last year. Vanguard cited bond price declines and record stock market highs, with the latter making any tax-loss harvesting in equities, "just about impossible to find." Here's what bond investors need to know about tax-loss harvesting to take advantage of the bond market selloff. Vanguard, iShares bond funds are among tax loss targets The recent selloff has given many investors an opportunity for tax-loss harvesting. Consider for instance, that the Vanguard Total Bond Market Index Fund ETF (BND) and the iShares Core U.S. Aggregate Bond ETF (AGG) are both down more than 3.5% year to date. "It's an opportunity to strike while the iron's hot because there's no guarantee that these losses are going to stick around," said Conor Kelly, a partner and senior financial advisor with Prime Capital Financial in Overland Park, Kansas. "You don't want to wait until year-end because these losses could disappear or at least shrink." Kristin Larson, founder and wealth advisor at NewSpring Wealth Partners in Minnetonka, Minn., said tax-loss harvesting in bonds is especially relevant now given the double-digit returns in stocks. The S&P 500, for instance, is up about 13% year-to-date. "For a lot of clients, the bond side of the portfolio is the only side that's down right now," Larson said. Cost basis analysis of the shares you hold is critical Don't look only at the current price of your fund to decide whether or not to sell. "It's not automatic that you'll have a tax loss just because an ETF has a negative price return for the year," said Bill Schwartz, managing director in the Potomac, Maryland, office of Wealthspire. For instance, if you bought the Vanguard Total Bond Market Index Fund ETF on Jan. 2 and didn't reinvest dividends or interest, you'd have a tax loss for the year to date because it has gone down in price. The ETF closed at 74.04 on Jan. 2 and was 71.40 on Sept. 21. "However, if you made multiple purchases over multiple years, there are no guarantees you'll have a tax loss," Schwartz said. Start by looking at the cost basis, or the purchase price of the shares plus any brokerage commissions or fees paid. Then, look at the difference between the current market value and the cost basis to determine whether you've had a gain or a loss on the sale. Keep in mind that when you reinvest dividends and interest, you're buying more shares of an investment, so your overall cost basis for the investment will increase. Your brokerage firm should keep track of this for you. It's important because it will help you determine which bonds to sell for tax-loss harvesting purposes. For simplicity, people might sell the entire position. Or, if they don't want the same exposure, they may want to switch to a different fund with a different credit quality or underlying index, said Mitch Schlesinger, chief investment strategist at Evermay Wealth Management in Arlington, Virginia. In this case, they'll look at the fund's aggregate cost basis, which is the average of all the purchases, plus dividends and interest. Identify specific positions that make for attractive tax-loss sales More commonly, however, advisors recommend investors look more granularly within the funds they own for tax-loss harvesting opportunities. Depending on when you bought the fund and reinvestments you've made, your portfolio could show an overall gain, but you might have specific positions that you can sell and use for tax-loss harvesting purposes. Let's say an investor owns 100 shares of XYZ bond ETF. You may have bought some shares two years ago and purchased more later on. In that simplified example, you'd have two different tax lots. Even if your entire position shows a gain, specific lots inside the broader position could be sitting at a loss — and it's those you want to address. "That's why it's critical that you can see the tax lot detail and not just the overall gain or loss," Larson said. Picking and choosing which lots to sell can be important based on when you bought the fund and your reinvestment patterns. An investor who bought an ETF in 2007, for example, might overall have some pretty substantial gains, Schlesinger said. "You need to look carefully at the individual lots that were purchased." Your financial advisors can help you determine which lots to sell. Or, if you don't work with an advisor, check your online statement for a detailed view of your cost basis for specific lots within a particular fund. If the information isn't readily available online, contact your custodian to ask how to get these specific details. Many online brokers have a tax optimization setting where it will automatically pick the most optimal lots for maximizing loss or minimizing gain, or you can manually select which lots you want, Schlesinger said. Be careful of the IRS wash-sale rule When you tax-loss harvest, you have to be careful about the wash sale rule, an IRS regulation that disallows a tax deduction for a loss on the sale of a security if you purchase a substantially identical security within a 61-day window (30 days before or after the sale). It involves making an investment decision on top of the tax decision, said Wealthspire's Schwartz. For instance, if you really like the position you're in and don't have a substantially different alternative, you might not want to sell shares. You can wait the 31 days and buy it back, but "you won't know the opportunity cost until those 31 days are up," he said. ETFs can make this investment sale and purchase process easier to complete. That said, there's less downside in bonds to sitting on the sidelines for a short window. It's easier to sell the bond positions with losses, even if they are small, because the downside to sitting in cash is limited compared with capturing losses in certain volatile stocks, said Prime Capital's Kelly. "In fixed income, simply sitting in cash for 30 days before repurchasing is much easier than sweating out sitting out of a stock for 30 days and seeing it jump up and move against you." Don't try to time the market Yields, which had dipped in recent days, could keep rising again, especially given the Federal Reserve's decision to raise interest rates last week and an indication of at least one more hike this year. Yields spiked on Wednesday after the latest economic data came in hot. Some investors may want to try and hold off a bit on harvesting losses, but it's hard to time. "You certainly could wait, and if rates continue to rise and bond prices fall further, you may have another opportunity to harvest an even larger loss," Schlesinger said. But he stressed that the loss you have today is known; the loss you might have tomorrow isn't. "Harvesting a loss today doesn't mean you're done for the year. If rates continue rising and new losses develop in other holdings or in the replacement investment, there may be additional opportunities later. Tax-loss harvesting opportunities are something to monitor throughout the year, not a single trade where you have to pick the perfect moment," he said. Schlesinger also pointed out that the Fed's actions are usually focused on a very short-term interest rate, or the Fed Funds rate, whereas longer-term Treasury yields are set by the market, not the Fed, and reflect expectations about inflation, economic growth and where investors think interest rates will be years from now. "So even if the Fed tells us more rate hikes are coming, the yield on a five- or 10-year bond doesn't necessarily have to rise. In fact, if investors believe additional Fed hikes will ultimately slow the economy and bring inflation down, longer-term yields could stay where they are or even decline. If that happens, bond prices could recover and today's tax-loss harvesting opportunity could shrink or disappear," Schlesinger said. "I wouldn't try to perfectly time the bottom in bond prices. If there's a meaningful loss today and we can harvest it while maintaining the investment exposure we want for our clients, there's value in taking the opportunity that's in front of us today," he added.
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