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Tax advice often involves avoiding realization of capital gains. But that can be the wrong advice when it comes to taxable bonds. Let's see why. (We'll ignore the effects of compounding to keep the math simple.)
Several years ago, an investor purchased $1 million of a Treasury note with a yield of 5 percent at par for his taxable account. The bond now has just one year left to maturity. Let's assume that the yield on a one-year Treasury note is now 1 percent. The investor has the following choices:
- He can hold the note to maturity and earn the 5 percent coupon.
- He can sell the note at a price of 104 and buy a one-year Treasury at par yielding 1 percent.
By holding the original note to maturity, the investor earns $50,000 and pays a tax of $17,500 for a net income of $32,500.
Now let's look at the case of selling the original note and buying a one-year note. The investor will have a long-term gain of $40,000 which will be taxed at 15 percent, producing a net gain of $34,000. That leaves him $1,034,000 to invest for one year at 1 percent, which produces income of $10,340. The income is taxed at 35 percent, producing net income of $6,721. All told, this investor has a net income at the end of the period of $40,721, an improvement of $8,221.
There are a few items to consider about this example. First, trading costs are ignored. However, the Treasury market is very transparent and is the most liquid in the world. Thus, trading costs should be very low and shouldn't exceed the benefit.
It's also important to note that trading costs are a function of the size of the transaction and liquidity of the market. The larger the amount involved, the more likely the investor would benefit from such a trade. Also, while liquidity for Treasuries and government agencies is high, the same isn't necessarily true of corporate bonds. Therefore, trading costs will be higher.
The bottom line is that the sharp drop in rates we have experienced and the current very steep yield curve has presented investors with an opportunity to arbitrage the tax system. And for many investors with large tax loss carry forwards, this would be a particularly advantageous time to convert ordinary income into capital gains. It's also worth noting that this is another example of the advantages of owning individual bonds instead of a mutual fund.
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