The Value of Tax Management for Bond Portfolios

Abstract

Taxes are an important issue in the management of bond portfolios for investors. The author reviews the benefits of trading municipal and high yield corporate bonds for the purpose of reducing taxes, thereby maximizing after-tax returns. Expected values for tax trading in the two markets are presented. The expected value of tax management is an ingredient that financial consultants should include in their asset allocation models for individual investors. In general, the value of tax trading increases with the average maturity of the portfolio and is sensitive to the investor's tax rates. With municipal bonds, investors should “harvest” losses and avoid gains. The value of tax managing municipal portfolios increases with maturity, but it also decreases as the investment horizon increases. Tax management of high-yield corporate bonds take advantage of the difference between the income and capital gains tax rates for individual and the timing of tax payments. Its value increases with maturity, but unlike municipal, it is not sensitive to one's investment horizon and the strategy entails realizing gains as well as losses.