The Risk/Return Benefits of Shorter-Term, High Quality Bonds

The Risk/Return Benefits of Shorter-Term, High-Quality Bonds

Alejandro Murguía, Ph.D., and Dean T. Umemoto, CFP

Executive Summary

• Fixed-income instruments are largely used within a portfolio to reduce volatility and provide a more consistent distribution stream for clients. Holding non-callable instruments backed by the U.S. government offer significant protection in times of financial crisis while reducing the long-term opportunity cost of bonds.
• U.S. government instruments with maturities from one to five years present the most favorable risk/reward profile. Additionally, the term premiums for extending maturities begin to decline for longer-term bonds.
• Mutual fund managers among the high-quality short-term (HS) and high-quality intermediate-term (HI) bond funds underperformed their corresponding government indexes and index funds over an entire decade. The average top quartile fixed-income managers in the HS and HI classes also underperformed their corresponding index funds.
• We analyzed the credit composition of the ten top-performing actively managed portfolios across the HS and HI mutual funds. Much of the value-added returns from these actively managed portfolios seem to stem from additional credit and call-option risk.
• There seems to be a direct inverse relationship between investment performance and fund expenses. The higher the investment return, the lower the fund expense ratio. Differences in expense ratios explain much of the differences in net returns.
• Further analysis of the top performing funds reveals that non-active strategies such as an indexing or variable maturity approach may be an investor's best option.

What Professionals Must Know to Tax-Manage Bonds

What Professionals Must Know to Tax-Manage Bonds

Ravi Agrawal, AAMS

Executive Summary

• Bond tax swaps can be an effective way of enhancing returns over a buy-and-hold strategy, but a comprehensive understanding of newer tax laws is essential to the outcome.
• Harvesting the capital gains of bonds has a high success rate, while harvesting the losses has a moderate success rate. Gain harvesting works best when interest rates have fallen sharply, the remaining maturities are short to intermediate, the premiums are high, and the issues are taxable. Loss harvesting is more successful when interest rates have risen sharply, the remaining maturities are long, the discounts are large, and the issues are municipals.
• Higher income tax rates and lower capital gains rates favor gain harvesting and diminish the benefits of loss harvesting.
• Harvesting capital losses is a common practice when interest rates rise. But this technique can be counterproductive, especially with shorter maturities, as additional taxes are often payable following a tax swap.
• The method of accounting for premiums and discounts is also important to success. Premiums of taxable bonds should be amortized annually and deducted against interest. Market discounts that are taxed are better deferred until maturity.
• Unbeknownst to some, all bonds bought at market discounts to issue price owe ordinary income taxes, even municipals.
• Under optimum accounting methods, discount taxable bonds have an after-tax edge over premium taxable bonds, and premium tax-exempt bonds have an edge over discount tax-exempt bonds.