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Nisha Patel

Financial Planning > Tax Planning > Tax Loss Harvesting

Bond Investors Could Score Major ‘Tax Alpha’ This Year

By John Manganaro

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What You Need to Know

  • With so much inflation and interest rate uncertainty, the bond markets are clearly in for a volatile ride during 2023.
  • Policy shifts could tee up some excellent tax loss harvesting opportunities in fixed income, Parametric's Nisha Patel says.
  • Patel says advisors should study up on tax loss harvesting and seek to implement the strategy year-round.

The exceptionally challenging year that was 2022 demonstrated to many investors that tax loss harvesting offers a silver lining to market sell-offs, and experts say 2023 could do much the same.

In fact, while a full-fledged repeat of 2022’s brutal market conditions in both equities and fixed income is unlikely, a high degree of volatility is not, says Nisha Patel, a managing director at Parametric Portfolio Associates who oversees the tax-advantaged bond strategies group.

As such, 2023 will likely prove to be a year in which systematic, year-round tax loss harvesting should be used to deliver potentially substantial tax alpha to clients. Notably, Patel says, the ongoing monetary policy shifts expected this year could tee up some excellent opportunities for clients to engage in tax loss harvesting within fixed income portfolios.

Those advisors not actively studying up on these opportunities risk falling behind their more tax-savvy peers, Patel says.

An ‘Unprecedented’ Year

Patel tells ThinkAdvisor that there are a number of words she could use to summarize the experience of overseeing fixed income portfolios in 2022, but she feels “crazy” is probably the most appropriate.

“I don’t think I’ve ever worked as hard as we did last year, working to keep our clients on the right course and to just keep people as calm as possible,” Patel says. “Since our focus is on separately managed accounts, and because one of the appeals of advisors using separately managed accounts is the ability to call up and speak with the manager, we spent a lot of time coaching and consoling clients.”

Echoing the sentiments of other bond market experts, Patel says many clients simply did not realize that the book value of high-grade bond portfolios could fall as quickly or as far as they did during the first half of 2022.

“Just like on the equity side, when clients see so much red in the fixed income portfolio, they have a tendency to want to sell and flee to safety,” Patel says. “So, our discussions probably looked a lot like what was happening on the equity side. We tried to show people that they were holding high-quality fixed income assets and that the best course of action was to ride out the shock.”

One of the helpful things Patel and her team could do was point to the silver lining of tax loss harvesting.

“As you know, pursuing this tax alpha was such an important thing in 2022,” Patel says. “The bad news was that portfolios were down as much as they were. Even investment-grade municipal bond portfolios were down in that 12% range at one point before they came roaring back. The lemonade, if you will, was that you could find those great buying opportunities and lock in higher book yields — while generating amazing tax alpha that we hadn’t really seen before.”

Patel says Parametric‘s clients ultimately enjoyed approximately 90 basis points of demonstrable tax alpha last year, which is about three to four times the typical amount generated in a year between 2012 and 2021.

Why Tax Loss Harvesting Could Shine Again in 2023

Given the significant disagreement and uncertainty with respect to inflation and interest rates, Patel says the bond markets are clearly in for a volatile ride during 2023. This should give investors a good chance to engage in year-round tax loss harvesting on this side of the portfolio.

“Systematically harvesting losses over the course of the year can produce a de facto tax asset, or realized losses, and can add considerable after-tax alpha to after-tax returns when used to offset future realized gains,” Patel explains. “These strategies are especially important for separately managed accounts because they can present more opportunities to harvest losses than mutual funds or exchange-traded funds.”

According to Patel, advisors typically review their portfolios for tax loss harvesting opportunities only in December, but the strategies become much more effective when assessed in a proactive, systematic manner throughout the year.

This is particularly true in fixed income portfolios, Patel says, wherein loss harvesting opportunities are mostly driven by changes in interest rates. Yearly rate peaks have historically been distributed throughout the calendar year, she notes.

Patel adds that tax loss harvesting strategies are a long-standing practice in equity portfolios, but they are still a relatively new development in fixed income SMAs. This is because wide bid-ask spreads and liquidity considerations historically precluded efficient execution of the strategy. Now, however, the rise of electronic execution has dramatically decreased corporate and municipal bid-ask spreads over the last several years.

(Pictured: Nisha Patel)

John Manganaro

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