How to climb from loss to gain on bonds

With a cycle of rising interest rates now seen as a foregone conclusion, this is a perfect time for financial advisers to start re-educating clients on how to make the most of what the market is about to give them. “It's a weird thing to say, but fixed-income losses can actually enhance a portfolio's return,” said J. Brent Burns, president of Asset Dedication LLC, which builds fixed-income separate -account portfolios. While it is true that most bond mutual funds will struggle to keep pace in a rising-rate environment, a shrewd manager of an individual bond portfolio could find some unique opportunities. One strategy that is likely to present itself is the opportunity to harvest tax losses when bond prices start falling as a result of the rising interest rates. Bond strategists are viewing this likely scenario as a kind of double bonus, which allows higher-income investors to take advantage of the higher income tax rates that now include a 3.8% Med-icare tax.

Offsetting equities

Unless a bond portfolio is structured as a ladder that is designed to hold individual bonds to maturity, advisers might want to consider selling existing bonds at a loss and using those losses to offset gains on the equity side of the portfolio. The fixed-income exposure that was sold at a loss can be easily replaced with comparable bonds paying a higher yield. “It's a way of turning a loss into an asset, and you can offset more gains when your tax bracket is higher, which allows you to take more risk,” said Harris May, president of Strategic Partners Investment Advisors Inc. “Tax harvesting is the most important function that a bond portfolio can provide to an investor,” he added. “For someone in a higher marginal tax bracket, the government is now more of a partner in helping you to recover your losses.” A rising-rate environment also presents opportunities for investors holding bonds to maturity. “Most bond mutual fund managers aren't able to hold a bond to maturity because of turnover and the internal structure of the portfolio, so they end up taking short-term bets and then closing out positions, which puts them in a hole each time they do it,” Mr. Burns said. “But if you're building a bond ladder, you're looking forward to rising rates.” If ever there was a time for a well-constructed bond ladder, it is a period such as now, which will enable investors to build a portfolio of bonds that should provide continuously higher yields. Mr. May cited a typical investment-grade 10-year municipal bond yielding 2% at the start of the year, compared with comparable muni bonds now yielding more than 3%. “That has been a great advantage for anyone in a laddered bond portfolio,” he said. “For the next 10 years, they will be building a ladder by investing in substantially higher yields.”

Holding to maturity

Mr. May added that the price-to-yield pattern in a rising-rate environment can also benefit clients who aren't building bond ladders, but are still intent on holding bonds to maturity. “If you know you're going to hold a bond to maturity, you will welcome the price discount that comes with rising rates because you can use the coupon payments to buy more of the same kind of securities paying a higher yield,” he said. “The point is, a bond portfolio should be managed with an eye on how it positively affects the entire portfolio, and if you're in a position to hold a bond to maturity and reinvest the coupons, you will have more income over the long term.”