Tax-Loss Harvesting: It’s Not Too Early

The markets and interest-rate environment are ripe for this strategy and there’s no need to wait until-year end.

Christopher Baccella

We all know that clients have been handed some very large losses recently by the market. But as advisors, we can’t run and hide. We must continue to provide counsel — even during tough times.

We also know from history that both the stock market and the U.S. economy should eventually recover and set new highs. Additionally, we know that bottoming is a process and will take time. On average, it takes three years for stocks to reclaim their previous highs. We are currently nine months into this bear market in both stocks and bonds.

Depending on your clients’ individual situations, now may be the time to consider tax-loss harvesting.

Investopedia describes tax-loss harvesting as, “… the timely selling of securities at a loss in order to offset the amount of capital gains tax due on the sale of other securities at a profit. This strategy is most often used to limit the amount of taxes due on short-term capital gains, which are generally taxed at a higher rate than long-term capital gains. However, the method may also offset long-term capital gains. This strategy can help preserve the value of the investor’s portfolio while reducing the cost of capital gains taxes.”

You don’t need to wait until year-end to do tax loss-harvesting. Your client portfolios are likely rife with opportunities. Keep the following in mind:

  • To harvest a loss, a position cannot be purchased within 30 days (before or after) of the harvesting trade. Otherwise, it becomes a wash sale.
  • You are not required to sell the entire position.
  • Ideally, you want to maximize short-term losses, which will offset against short-term gains (if any) and are typically taxed at higher rates.
  • You can go to cash or purchase a vehicle that is not “substantially identical,” per IRS regulations. Therefore, if you sell a stock, you can invest the proceeds into a bond, mutual fund or another stock.
  • You can use this opportunity to rebalance the portfolio, change asset allocations, exit high risk positions, etc.
  • You could even use this opportunity to bottom-fish for more oversold opportunities, and/or offset gains in long-term holdings.
  • Clients can typically offset all realized gains in non-qualified accounts, plus up to $3,000 against ordinary income. Losses can be carried forward indefinitely and offset against gains in future years.

Repositioning for the current environment

One non-traditional idea would be to look at harvesting losses in your clients’ bond mutual funds and reallocating these assets to individual bonds. We expect interest rates will continue to rise through the remainder of 2022, with Fed funds reaching a high of about 4%. Nearly all bond funds will continue to experience unrealized losses in a rising interest rate environment.

Instead, clients may be better off owning quality individual bonds with a defined maturity. As bonds approach maturity, their interest rate sensitivity declines (i.e., a 5-year bond becomes a 4-year, then a 3-year, 2-year and 1-year), and the bond eventually pays out par (assuming no default). The investor’s return was the yield to maturity (or yield to call) that they agreed to at the time of purchase. Fund investors do not benefit from this final maturity.

Much — but maybe not all — of the Fed’s anticipated interest rate increases appear to have been priced into bonds. As of September 28, 2022, 2-year Treasuries yield 4.14%, up from just 73 basis points at the start of the year — an increase of 340 basis points. The current yield curve plateaus to the 3-year Treasury and then starts to drop.

In brief, 5-year Treasurys now yield 3.95% (+269 basis points YTD), 10-year Treasurys yield 3.73% (+222 basis points YTD), and the 30-yr long bond yields 3.70% (+180 bps YTD).  Thus, the much-watched 2-to-10 spread is inverted by about 40 basis points, and (still) forecasts a recession in the next six months.  Also, notice that yields on longer-dated securities haven’t risen as much, with 30-year yields lower than 10-year yields.

Of course, the upshot to rising rates is that yields are higher. For example, a 3-year A/A- bonds is currently being offered at 5.2%. Unfortunately, with their legacy holdings, bond funds may need to wait for maturities or cash flows to take advantage of these higher yields. We continue to recommend staying in the 3- to 6-year part of the yield curve with the bulk of client’s fixed income portfolios.

Seek quality

We continue to recommend focusing on quality investments. That means companies with actual earnings, strong balance sheets and strong businesses. If the economy continues to deteriorate, quality companies are more likely to survive — and ultimately —thrive.

On the other hand, financially weak companies are more likely to become stressed, resulting in deteriorating balance sheets and tougher credit conditions. They’re also likely to cut costs too deeply, lose talented employees, and possibly even go bankrupt or be forced to find a suitor.

Parting thoughts

Remember, about 40% of S&P 500 revenue is generated from outside the U.S. Therefore, what happens in China, Europe, Latin America, etc., will eventually be felt here. Many of those economies are currently facing worse conditions than the U.S. and are exacerbating our domestic weakness.

It’s also important to avoid junk. By this, we mean below-investment-grade debt. It may be tempting to reach for yield, and some talking heads will point to historic default rates around 2%. But they fail to mention that prices are highly correlated with the stock market and that in recessions, these default rates often spike into the high teens.  Finally, we urge caution when indexing in junk through a fund or ETF. These funds are overweighted to the largest issuers (most debt outstanding) — which may not be the best idea.

We must help our clients navigate these uncertain and historic times. While bear markets are tough to go through, they do offer opportunities to reposition portfolios along the way. Taking advantage of these opportunities can help your clients come out further ahead, compared with a simple rebalancing or buy-and-hold strategy, and it cements your value as their advisor.

Christopher Baccella, CFA, a wealth advisor with Mariner Wealth Advisors, develops personalized wealth management solutions for clients to help them achieve their goals and to grow and protect their wealth, and provides investment management services to institutional clients. Chris has over 16 years of experience in the wealth management industry. He can be reached at [email protected].


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