Bond Holdings Can Improve Portfolio Tax Efficiency.

Today tax efficiency is a popular but confusing topic of discussion among many fixed income and equity investors. The intent of this article is to clarify some of the issues involved in managing investments for tax efficiency. We will briefly address how to obtain the best after-tax returns for a bond portfolio, resolve some common misconceptions with regards to tax-efficient fixed income investing, and discuss how your bond portfolio can add significant tax efficiency to your overall portfolio.

A good place to start clearing up some of the confusion is with a discussion of the meaning of tax efficiency and after-lax returns. Basically, a tax efficient investment decision will leave more after-tax dollars in an investor's pocket. By way of contrast, after-tax returns simply mean the measurement of investment returns on an after-tax basis. And because higher after-tax returns leave more after-tax dollars in an investors pocket, the maximization of after-tax returns is the first step in constructing a tax efficient portfolio. The second step in constructing the tax efficient portfolio is to make investment decisions that either reduce your tax bill while leaving your income unchanged or increase your income without increasing your tax bill.

The critical point to emphasize when attempting to maximize after-tax fixed income returns is that over long time horizons at least 90% of a bond's total return will come from income and that only 10% or less will come from capital gains. It also helps to realize that income tax rates are much higher than long-term capital gains tax rates. As a result, managing the income tax efficiency of a bond portfolio (maximizing after-tax income) is the key to optimizing after-tax fixed income returns.

At this point, many investors would wrongly conclude that investing in the appropriate state-specific municipal mutual fund would achieve tax efficiency. But this can be a costly mistake for two reasons. First, an investor can maximize long-term returns by buying the most generous after-tax (fixed) income streams available. Sometimes the best sources of after-tax income are found in higher-yielding taxable bond sectors, such as the corporate or mortgage-backed sectors, rather than in the municipal bond market. Second, if the investor puts his money in a state-specific mutual fund, he loses the ability to invest according to his specific tax circumstances. Both of these points mean that the investor who chooses a state specific mutual fund is not likely to achieve optimal after-tax returns.

This is the point where some investors might argue that the option to manage their specific tax circumstance is not of significant value because capital gains and losses, and their related tax consequences, should not be material over the long run. Their reasoning is that gains in one year are offset by losses in another year as interest rates move up and down. This may be true, but short term gains are treated as ordinary income and are taxed at a rate that is nearly double the 20% long term capital gains tax rate.

However, in practice, the tax efficiency that a separately managed fixed income portfolio can deliver, does matter. Specifically, an investment manager who is effective at managing both the income and the capital gains tax components is likely to consistently add between 0.40% to 0.60% of additional after-tax returns relative to other less-effective managers. This may seem trivial, but the value added over the course of a decade to an initial fixed income investment of $100,000, that grows at an after-tax rate of 7% instead of 6.5%, is a little over $9,000. Said differently, tax efficiency of this magnitude is worth roughly a decade of management fees.

Still for the many investors that have become accustomed to the 20% plus annual total returns provided by the equity market in recent years, adding one half of one percent in the form of tax efficiency to your bond portfolio may still seem unimportant However, in our opinion, this is precisely the point at which things can become very interesting. This is where we examine ways of constructing a client's portfolio that will either reduce his tax bill while leaving his income unchanged or increase his income without increasing his tax bill.

We are often able to add this type of efficiency for Investors that have built substantial capital gains in their equity portfolios during the past decade long bull market. Specifically, these investors can often add substantial tax efficiency to their overall investment portfolio through the active management of their bond holdings. These investors may reasonably expect to realize or budget for sizable capital gains in their equity portfolio over time. These capital gains, however, often result in an investor being subject to the Alternative Minimum Tax (AMT). In practice, an investor can sometimes recapture more than 80% of this additional tax bill by shifting a portion of their tax-exempt municipal assets into taxable bond sectors. Essentially, the investor earns more income without increasing his tax bill. This added value is often more than enough to offset multiple years' of management fees on a bond portfolio! For example, take an investor that has a $500,000 balanced portfolio, with $300,000 in equit ies and $200,000 in municipal bonds and a desire to realize a $50,000 gain in his equity holdings. In this case, realizing the capital gain causes the investor's AMT bill to be roughly $4,000 higher than his regular tax bill. While the investor has to pay the higher AMT bill, he can recapture roughly $3,600 of these additional tax dollars by shifting two thirds of his municipal bonds to taxable fixed income. With fixed income management fees of 0.60% in this example, $3,600 represents three years of fees.

In addition to being meaningful, this type of tax planning is robust. An investor does not need to be precise when estimating expected capital gains in order to realize a benefit from this type of tax optimization. In fact, in the above example the investor could shift two thirds of his municipal assets to taxable fixed income based on his expectation of realizing a $50,000 capital gain and even if he later only realizes $20,000 of the budgeted gains, he still does not reduce his after-tax income.

Hopefully, it has become somewhat clearer that constructing tax efficient portfolios means more than maximizing after-tax fixed income or equity returns. It also involves tax planning that accounts for all of a client's investments. And this planning can lead to strategies where the active management of bond holdings can significantly improve the tax efficiency of the overall portfolio. And finally, investors that thought they just needed a good municipal bond manager might find it beneficial to employ one that also excels at the management of taxable fixed income!

Eric C. Reynolds is Senior Vice President for Fiduciary Trust International of California.