Techniques to Lower Your taxes and Improve the Quality of Your Portfolio
What is a Bond Swap?
A bond swap is a technique whereby an investor chooses to sell a bond and simultaneously purchase another bond with the proceeds from the sale. Fixed-income securities make excellent candidates for swapping because it is often easy to find two bonds with similar features in terms of credit quality, coupon, maturity and price.
In a bond swap, you sell one fixed-income holding for another in order to take advantage of current market and/or tax conditions and better meet your current investment objectives or adjust to a change in your investment status. A wide variety of swaps are generally available to help you meet your specific portfolio goals.
Why You Would Consider Swapping
Swapping can be a very effective investment tool to:
- increase the quality of your portfolio;
- increase your total return;
- benefit from interest rate changes; and
- lower your taxes.
These are just a few reasons why you might find swapping your bond holdings beneficial. Although this booklet contains general information regarding federal tax consequences of swapping, we suggest you consult your own tax advisor for more specific advice regarding your individual tax situation.
Swapping for Quality
A quality swap is a type of swap where you are looking to move from a bond with a lower credit quality rating to one with a higher credit rating or vice versa. The credit rating is generally a reflection of an issuer’s financial health. It is one of the factors in the market’s determination of the yield of a particular security. The spread between the yields of bonds with different credit quality generally narrows when the economy is improving and widens when the economy weakens. So, for example, if you expect a recession you might swap from lower-quality into higher-quality bonds with only a negligible loss of income.
Standard rating agencies classify most issuers’ likelihood of repayment of principal and payment of interest according to a grading system ranging from, say, triple-A to C (or an equivalent scale), as a quality guideline for investors. Issuers considered to carry good likelihood of payment are “investment grade” and are rated Baa3 or higher by Moody’s Investors Service or BBB- or higher by Standard & Poor’s Ratings Services and Fitch Ratings. Those issuers rated below Baa3 or below BBB- are considered “below investment grade” and the repayment of principal and payment of interest are less certain. Suppose you own a corporate bond rated BBB (lower-investment-grade quality) that is yielding 7.00% and you find a triple-A-rated (higher-investment-grade quality) corporate bond that is yielding 6.70%.1 You could swap into the superior-credit, triple-A-rated bond by sacrificing only 30 basis points (one basis point is 1/100th of one percent, or .01%). Moreover, during an economic downturn, higher-quality bonds, which represent greater certainty of repayment in difficult market conditions, will typically hold their value better than lower-quality bonds.
Also, if a market sector or a particular bond has eroded in quality, it may no longer meet your personal risk parameters. You may be willing to sacrifice some current income and/or yield in exchange for enhanced quality.
Swapping to Increase Yield
You can sometimes improve the taxable or tax-exempt returns on your portfolio by employing a number of different bond-swapping strategies. In general, longer-maturity bonds will typically yield more than those of a shorter maturity will; therefore, extending the average maturity of a portfolio’s holdings can boost yield. The relationship between yields on different types of securities, ranging from three months to 30 years, can be plotted on a graph known as the yield curve. The curve of that line is constantly changing, but you can often pick up yield by extending the maturity of your investments, assuming the yield curve is sloping upward. For example, you could sell a two-year bond that’s yielding 5.50% and purchase a 15-year bond that is yielding 6.00%. However, you should be aware that the price of longer-maturity bonds might fluctuate more widely than that of short-term bonds when interest rates change.
When the difference in yield between two bonds of different credit quality has widened, a cautious swap to a lower-quality bond could possibly enhance returns. But sometimes market fluctuations create opportunities by causing temporary price discrepancies between bonds of equal ratings. For example, the bonds of corporate issuers may retain the same credit rating even though their business prospects are varying due to transient factors such as a specific industry decline, a perception of increased risk or deteriorating credit in the sector or company. So, suppose you purchased in the past (at par) a 30-year A-rated $50,000 corporate bond with a 6.25% coupon. Assume that comparable bonds are now being offered with a 6.50% coupon. Assume that you can replace your bond with another $50,000 A-rated corporate bond having the same maturity with a 6.50% coupon. By selling the first bond and buying the second bond you will have increased your annual income by 25 basis points ($125). Discrepancies in yield among issuers with similar credit ratings often reflect perceived risk in the marketplace. These discrepancies will change as market conditions and perceptions change.
Swapping for Increased Call Protection
Swaps may achieve other investment objectives, such as building a more diversified portfolio, or establishing better call protection. Call protection is useful for reducing the risk of reinvestment at lower rates, which may occur if an issuer retires, calls or pre-refunds its bonds early. Call protection swaps are particularly advantageous in a declining interest rate environment. For example, you could sell a bond with a short call, e.g., five years, and purchase a bond with 10 years of call protection. This will enable you to lock in your coupon for an additional five years and not worry about losing your higher-coupon bonds in the near future. You may have to sacrifice yield in exchange for the stronger call protection.
Anticipating Interest Rates
If you believe that the overall level of interest rates is likely to change, you may choose to make a swap designed to benefit or help you protect your holdings.
If you believe that rates are likely to decline, it may be appropriate to extend the maturity of your holdings and increase your call protection. You will be reducing reinvestment risk of principal and positioning for potential appreciation as interest rates trend down. Conversely, if you think rates may increase, you might decide to reduce the average maturity of holdings in your portfolio. A swap into shorter-maturity bonds will cause a portfolio to fluctuate less in value, but may also result in a lower yield.
It should be noted that various types of bonds perform differently as interest rates rise or fall, and may be selectively swapped to optimize performance. Long-term, zero-coupon2 and discount bonds3 perform best during interest rate declines because their prices are more sensitive to interest rate changes. Floating-rate, short- and intermediate-term, callable and premium bonds4 perform best when interest rates are rising because they limit the downside price volatility involved in a rising yield environment; their price fluctuates less on a percentage basis than a par or discount bond.
However, you should remember that rate-anticipation swaps tend to be somewhat speculative, and depend entirely on the outcome of the expected rate change. Moreover, shorter- and longer-term rates do not necessarily move in a parallel fashion. Different economic conditions can impact various parts of the yield curve differently. To the extent that the anticipated rate change does not come about, a decline in market value could occur.
Swapping to Lower Your Taxes
Tax swapping is the most common of all swaps. Anyone who owns bonds that are selling below their amortized purchase price and who has capital gains or other income that could be partially, or fully, offset by a tax loss can benefit from tax swapping.
You may have realized capital gains from the sale of a profitable capital asset (e.g., real estate, your business, stocks or other securities). Or you may expect to sell such an asset at a potential profit in the near future. By swapping those assets that are currently trading below the purchase price (due to a rise in interest rates, deteriorating credit situation, etc.) you can reduce or eliminate the capital gains you would otherwise have paid on your other profitable transactions in the current tax year.
The traditional tax swap involves two steps: (1) selling a bond that is worth less than you paid for it and (2) simultaneously purchasing a bond with similar, but not identical, characteristics. For example, assume you own a $50,000, 20-year, triple-A-rated municipal bond with a 5.00% coupon that you purchased five years ago at par. If interest rates increase (such that new bonds are now being issued with a 5.50% coupon), the value of your bond will fall to approximately $47,500. If you sell the bond, you will realize a $2,500 capital loss, which you can use to offset any capital gains you have realized. If you have no capital gains, you can use the capital loss to offset ordinary income. You then purchase in the secondary market a replacement triple-A-rated 5.00% municipal bond (from a different issuer), maturing in 15 years, at an approximate cost of $47,500. Your yield, maturity and quality of bond will be the same as before, plus you will have realized a loss that will save you money on taxes in the year of the bond sale. Of course, if you hold the new bond to maturity, you will realize a $2,500 gain in 15 years, taxable as ordinary income at that time. By swapping, you have converted a “paper” loss into a real loss that can be used to offset taxable gain.
Some Important Rules for Tax Swapping
Under current tax law, the maximum tax rate on long-term capital gains is lower than the maximum rate on short-term capital gains. In order to be entitled to the lower long-term capital gains rate, a taxpayer must hold the asset for more than one year. Because of ongoing discussions concerning possible changes in the tax treatment of capital gains, investors should consult their tax advisor for up-to-date advice.
Capital losses from swap transactions are reflected on Schedule D of your tax return. If you have short-term or long-term capital gains, the losses from the swap transactions will offset these gains first—long-term losses will offset long-term gains, and short-term losses will offset short-term gains; net losses in either category will then offset gains in the other category. If the net result is an overall capital loss, the excess loss can be used to offset ordinary income dollar-for-dollar (up to a maximum of $3,000). If an investor has both net short-term and net long-term capital losses, the ordinary income is first offset by the short-term capital losses, then by the long-term losses. Excess capital losses can be carried forward indefinitely to reduce capital gains liability and ordinary income in future years.
The tax basis of the new bonds will be their cost (the price paid for the bonds). If the new bonds are bought at a discount and held to maturity, or are sold at a price higher than their cost, a taxable gain will often result, unless also offset by losses. To the extent such gain represents accrued market discount, it will be taxed as ordinary income, with the balance treated as capital gain.
Ask your tax advisor about the use of original-issue discount or market discount bonds, or the use of bonds issued at a premium, in tax swaps.
Other Tax Strategies
Changes in the tax laws always present an opportunity to review your bond holdings.
Investors who expect their tax rate to increase will frequently swap taxable bonds for tax-exempt (municipal) bonds. This is done with the expectation that tax-exempt bonds will become relatively more desirable in the marketplace than fully taxable bonds and will benefit from price appreciation.
Investors not subject to the Alternative Minimum Tax (AMT) can obtain additional yield by purchasing municipals that are subject to that tax. Taxpayers who are subject to AMT can save taxes by swapping to non-AMT bonds.
How to Avoid a Wash Sale
The Internal Revenue Service will not recognize a tax loss generated from the sale and repurchase within 30 days before or after the trade or settlement date of the same or a substantially identical security—typically called a “wash sale.” While the term “substantially identical” has not been explicitly defined in this context, two bonds have generally not been considered substantially identical if (1) the securities have different issuers, or (2) there are substantial differences in either maturity or coupon rate.
For a Personal Appraisal
To learn more about what bond swapping may mean to you, consider your objectives and discuss them your financial consultant.
Swap Objectives and General Information
- Do you wish to establish a tax loss or realize a gain?
- Do you wish to improve quality?
- Do you wish to increase yield?
- Do you wish to increase call protection?
- Is there a change in your tax status?
- What is your tax bracket?
- What type of bond are you swapping?
- Do have any other specific investment parameters?
To accomplish any of these objectives are you willing to…
- Extend maturity? _____Yes _____No
- Adjust credit ratings? _____Yes _____No
- Invest additional funds? _____Yes _____No
Bonds for Review
- Face Amount
- Issuer and Description
- Maturity Date
- Purchase Cost
- Date of Purchase
- CUSIP Number
- All examples are for illustrative purposes and are not representative of actual market yields.
- A zero-coupon bond is a bond for which no periodic interest payments are made.
- The investor receives one payment at maturity equal to the principal invested plus interest earned compounded semiannually at the original interest rate to maturity.
- A discount bond is a bond sold at less than par.
A premium bond is a bond priced greater than par.