Sell Long term bonds with large gain for short term bonds

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privateID
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Sell Long term bonds with large gain for short term bonds

Post by privateID »

A relative who I'm helping out with their finances is in the 28% fed tax bracket and also have a state tax. They own 3 Vanguard bond funds: Long Term bond, Long Term Invest-Gr, Long Term Treasury. All have decent capital gains (total around 10K). I prefer bonds as the rock and don't wish to take chances with bonds. They also have a decent holding in Limited-Term tax-Exempt and any new money is going into that fund.

I'm looking for opinions if it's worth it for them to sell these funds to get to a desired AA or perhaps just keep these funds because of the capital gains? There's a part of me that thinks these funds have all had a nice ride, so even though there would be cap gains, it is worth it. On the other hand, I hate to realize cap gains without a hard purpose.

Thoughts?

Thanks
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Re: Sell Long term bonds with large gain for short term bond

Post by scone »

Don't sell if you can help it. Instead, calculate the duration of the entire bond portfolio. If it's too far beyond intermediate, then add more money to the short end, if you can. At any rate, if all new money is going to the short term fund, your overall duration should be falling anyway, and that may be good enough. Personally, I would not want to go so short that I'm losing money after inflation, but that's just me.
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Re: Sell Long term bonds with large gain for short term bond

Post by Longdog »

scone wrote:Don't sell if you can help it. Instead, calculate the duration of the entire bond portfolio. If it's too far beyond intermediate, then add more money to the short end, if you can. At any rate, if all new money is going to the short term fund, your overall duration should be falling anyway, and that may be good enough. Personally, I would not want to go so short that I'm losing money after inflation, but that's just me.
You could reinvest distributions from the longer term funds into shorter term funds, to cause a gradual reduction in duration and avoid paying cap gains tax.
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ogd
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

I would argue that term risk ("length") should be the exception to the "bonds are for safety" mantra. There is even a theoretical argument: long bonds "freeze" current yields, for better or worse, for longer periods of time, even in the face of deflation, which can be easily seen as safety. Which is why long bonds are often used in liability matching portfolios, e.g. you know you'll be able to pay that mortgage from a long bond, whereas a short one could in the near future see yields too low to support the mortgage payment. For this argument you need to consider how much nominal vs inflation-adjusted income you need.

More importantly, in practice we see long bonds actually reduce the volatility of high-equity portfolios better than intermediate or short bonds. I'm talking 80%+ equities. So if you interpret "bonds are for safety" as applying to the entire portfolio rather than just the bond portion, long bonds fill that role even better. For less aggressive portfolio, the volatility of the long bonds tends to show up too much.

I'd say if your relative has less than 80% equities, they should thank their lucky stars (long bonds have done amazingly well recently) and switch to a single intermediate fund, where they should have been from the beginning (chasing yields might have played a part in the switching). I would take the capital gains, since the alternative means for bonds to return income (interest) is far worse. Bond capital gains don't accumulate for long term tax deferral, like they do for equities. I would probably wait for them become long term gains, though, if they're short right now.

At 80% or above, it's fine to leave it as it is.

They should also consider CDs and municipal bond funds, if you ask me. CDs at 2.25% are IMHO the most attractive option right now if account logistics allow it.
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Re: Sell Long term bonds with large gain for short term bond

Post by scone »

SteveM wrote:
scone wrote:Don't sell if you can help it. Instead, calculate the duration of the entire bond portfolio. If it's too far beyond intermediate, then add more money to the short end, if you can. At any rate, if all new money is going to the short term fund, your overall duration should be falling anyway, and that may be good enough. Personally, I would not want to go so short that I'm losing money after inflation, but that's just me.
You could reinvest distributions from the longer term funds into shorter term funds, to cause a gradual reduction in duration and avoid paying cap gains tax.
That's true. If you could do it with a minimum of hassle and trading fees, that would be great. Even better if it were fully automated. The short end earns so little these days, every penny counts-- even more than usual.
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privateID
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

Thanks for the replies. Some other points based on the replies:

1) The income from the bonds is generally not needed, although who knows in the future.

2) The two biggest current bond holdings are intermediate-term bond index in an IRA and limited-term tax-exempt bond in taxable. These other bond funds are smaller, but a decent enough size.

3) Already reinvesting any dividends into the limited-term tax-exempt.

If my two main concerns are tax-efficiency and preservation of principal, would Long Term Invest-Gr be the first to sell? Perhaps followed by the Long Term bond index and then Long Term Treasury? If so, maybe we start by selling Long Term Invest-Gr.

We spoke to a Vanguard financial planner and they recommended selling all 3 funds mainly due to tax-efficiency.
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Re: Sell Long term bonds with large gain for short term bond

Post by staythecourse »

Are they in taxable bonds in taxable account because it favors them? I know that is not the question, but first would question the asset location story. They are in the 28% tax bracket so this is where you start seeing adv. for tax exempt anyways. Just remember all those income distributions are being taxed at ordinary rates as well.

I do agree the easiest will be if you want to make this change to just reinvest the distributions into whatever else you want. Also who knows how the year will go, but if something tanks in the portfolio you can TLH at that time to negate the LT bonds at that time. For example, if TSM is held and tanks and you TLH for 10k loss then you can offset that partially for the capital gains if you decided to sell the LT bonds at that time. Of course, the nuances of balancing out short and long losses need to be kept in mind.

Good luck.
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

First, I would not recommend that anyone invest in Limited Term Tax Exempt currently. The SEC yield is so low that even a savings account at 1% (e.g. Barclay's) makes almost that much after taxes, and the savings account has infinitely less risk and infinitely more liquidity. Recent returns for Ltd-TxEx are high, but going forward we are at much lower yields than a year ago, say. For munis, it's intermediate or none at all.

Second, assuming the points made above about high-equity portfolios and long bonds, and staythecourse's question about asset location, are not an issue, I would indeed sell all of the long funds (no need to go through any stages) and buy intermediate munis and/or CDs. This will also make for a simpler portfolio.

Note that Vanguard will never tell you to go to this or that bank and buy their CD or savings account. They just don't track those deals and it's up to us. Both products are a very good alternative right now.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

The taxable bonds are in taxable accounts because that's where they were when I started to help. In fact, there are 2 other bond funds (TBM and TIPS) also held in taxable accounts, but I thought I'd focus on the low hanging fruit (the long term bonds). The TBM and TIPS are at least admiral shares. The long-term bond funds are not admiral shares (although close). So I am working with a bit of scattering of funds and trying to slowly make improvements where it makes sense.

ogd - Interesting comments about Limited Term. Bonds have always been a somewhat confusing topic for me (I am learning quick as I help out) mostly because I have not had to make these kind of decisions for myself. Looking at the difference between short-term to limited term to intermediate term, I currently see:
Yield: 0.42%, 0.89%, 1.68%.
Avg maturity: 1.4, 3.3, 8.8
Avg duration: 1.0, 2.5, 4.8

Can you elaborate on why only intermediate munis? These numbers seem consistent, where more reward for longer maturity. Although a yield of 0.89% is not great, neither is 1.68%. If rates rise, then these yields will all rise.
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID wrote: ogd - Interesting comments about Limited Term. Bonds have always been a somewhat confusing topic for me (I am learning quick as I help out) mostly because I have not had to make these kind of decisions for myself. Looking at the difference between short-term to limited term to intermediate term, I currently see:
Yield: 0.42%, 0.89%, 1.68%.
Avg maturity: 1.4, 3.3, 8.8
Avg duration: 1.0, 2.5, 4.8

Can you elaborate on why only intermediate munis? These numbers seem consistent, where more reward for longer maturity. Although a yield of 0.89% is not great, neither is 1.68%. If rates rise, then these yields will all rise.
These numbers make sense ("are consistent") in the market, but you as a small investor have access to some investments the market can't use and thus can't price properly like it normally does. In particular, a 1% savings account which makes more than any market bonds below 3 years while being completely free of risk and as a result "cuts short" our interest in market bonds at about the three year mark. This is not unique to munis, but applies to all short bonds.

If you had such an account and paid 28% taxes, you'd be left with 0.78%, but this is 100% safe money with perfect liquidity. Is it worth taking both term and credit risk for another 0.11%? Not in my book. (Note: state taxes are a wash because you have to pay them on both).

This situation can and will change. In 2011 at 1.5% SEC yield, Ltd-Term was definitely worth it and it may become so again. Right now, it isn't. It's one of the rare cases when we get to make "market" timing moves, because bank products are insulated from the market and sometimes have weird pricing that we can take advantage of. The savings account should by market standards yield 0.1%, so the 1% is a gift we should take advantage of.

The intermediate funds at least compensate you a lot more for the risk, although I'd say CDs are still better right now. But it's less clear cut.
privateID wrote:The taxable bonds are in taxable accounts because that's where they were when I started to help. In fact, there are 2 other bond funds (TBM and TIPS) also held in taxable accounts, but I thought I'd focus on the low hanging fruit (the long term bonds). The TBM and TIPS are at least admiral shares. The long-term bond funds are not admiral shares (although close). So I am working with a bit of scattering of funds and trying to slowly make improvements where it makes sense.
I would recommend trying to move bonds into tax-advantaged accounts to the degree possible, before making moves into municipal bonds. It should be the first step in the fixed income plan.
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Re: Sell Long term bonds with large gain for short term bond

Post by Kevin M »

Pretty much agree with almost everything ogd said. I eliminated my Limited Term Tax-Exempt Bond position a couple of years ago (when CDs became relatively more attractive for me in taxable), and now hold only intermediate and long-term bond funds, balanced with 70% of fixed income in CDs.

Note that "long-term" tax-exempt bond funds are not nearly as long-term as corporate or investment-grade bond funds. The former have durations on the order of 6-7 years, while the latter are more in the 15-year range. On the other hand, it has been pointed out that the tax-exempt bond fund durations may be understated based on actual price/yield changes and on looking at actual fund holdings. I own all of the above, but am not a role model for simplicity.

One point that some Bogleheads disagree with is to place a priority on holding bonds in tax-advantaged accounts (although the latter probably is the majority opinion). A couple of forum members who publish blogs (tfb, EmergDoc) have suggested that one should do just the opposite, since what matters is not relative tax efficiency but absolute tax efficiency (the latter factors in expected returns, the former does not). I am neutral on this, and hold bonds and CDs in both taxable and tax-advantaged accounts. At current low rates, I don't think it makes much difference.

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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

Kevin, ogd - Thanks. You definitely gave me something to think about. I have never really played the rate game before for myself (most of my bond holdings are in a stable value fund in my 401K, some TIPS in an IRA and some I-bonds). They do own an AmEx account that pays 0.8% interest. The idea of switching banks, or opening another account for 0.2% seems like a hassle (I'm trying to make things simpler for them). That's $200 for every $100K, then subtract taxes. My plan was to go a bit longer than the Limited-Term but not as long as the Intermediate-Term. In the taxable, the short term bond fund pays less interest, which means less taxes. So, I thought I'd go longer in the IRA, so that the combined average term is in-between the Limited-Term and Intermediate-Term and would be a reasonable safe return. Regardless, I will definitely think about it more.

As far as the long term bond situation, I'm leaning toward selling the Long Term Invest-Gr for now. I believe it is the most tax-inefficient of the three mentioned. I may end up selling all of them, but there is no rush.
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Re: Sell Long term bonds with large gain for short term bond

Post by Kevin M »

privateID wrote:In the taxable, the short term bond fund pays less interest, which means less taxes. So, I thought I'd go longer in the IRA, so that the combined average term is in-between the Limited-Term and Intermediate-Term and would be a reasonable safe return. Regardless, I will definitely think about it more.
This actually makes sense, and is what some Bogleheads have mentioned they do; i.e., hold shorter-term, low-yield fixed income in taxable, and longer-term, higher-yield in tax-advantaged.

In terms of bond funds, I personally hold only intermediate/long-term tax-exempt bond funds in taxable, and intermediate/long-term investment-grade bond funds in tax-advantaged. As mentioned already, I hold CDs in both, but that's not necessarily optimal for your friend.
privateID wrote:As far as the long term bond situation, I'm leaning toward selling the Long Term Invest-Gr for now. I believe it is the most tax-inefficient of the three mentioned. I may end up selling all of them, but there is no rush.
I hold some of this fund in tax-advantaged, but it's a very small portion of my portfolio; I wouldn't hold much of it. It's kind of my canary in the coal mine; when interest rates start to increase across the board, it'll take the biggest hit. When its SEC yield hits 5% I'll buy more, and start paying more attention to my intermediate-term funds (waiting for their yields to hit 5% so I can buy more). Of course there's always the chance that this won't happen in my lifetime.

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Re: Sell Long term bonds with large gain for short term bond

Post by stlutz »

First, I would not recommend that anyone invest in Limited Term Tax Exempt currently. The SEC yield is so low that even a savings account at 1% (e.g. Barclay's) makes almost that much after taxes, and the savings account has infinitely less risk and infinitely more liquidity. Recent returns for Ltd-TxEx are high, but going forward we are at much lower yields than a year ago, say
Actually, the current SEC Yield of Limited Term Tax Exempt is .89%, which happens to be the *exact* same yield it had 1 year ago. Yet, in 2014 the *income* portion of this fund's return was 1.69%! After tax, this is more than twice the income of the savings account. Given that rates on the longer end of the curve have dropped in the past year, I'd expect this premium to shrink in 2015, but it's an illustration of a point I've been making several times lately--the SEC Yield of a bond fund is not the same thing as the APY of a savings account or CD, and using these two numbers to play market-timing games with the bond market can produce unpredictable results.

I would back up and start over. You and your relative should ask, "What type of bonds do I want to own?" Based on the priority of preserving capital, I think anything but a token allocation to long-term bonds probably doesn't make sense in that case. Personally, I agree with ogd that just using short-to-intermediate term bonds is a good bet.

Once you've figured out what the portfolio overall should look like, then look at how to get from the current portfolio to the desired portfolio, what should be in taxable vs. tax-advantaged accounts etc. Even at this point, if the funds being held are not appropriate based on the overall strategic analysis, it's better to sell and pay capital gains tax than to take risks that you don't want to take to avoid taxes that you'll [hopefully] have to pay at some point regardless.
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

stlutz wrote:Actually, the current SEC Yield of Limited Term Tax Exempt is .89%, which happens to be the *exact* same yield it had 1 year ago. Yet, in 2014 the *income* portion of this fund's return was 1.69%! After tax, this is more than twice the income of the savings account. Given that rates on the longer end of the curve have dropped in the past year, I'd expect this premium to shrink in 2015, but it's an illustration of a point I've been making several times lately--the SEC Yield of a bond fund is not the same thing as the APY of a savings account or CD, and using these two numbers to play market-timing games with the bond market can produce unpredictable results.
Ah, caught me red handed. Might be time to update my "last year" line which worked off the September 2013 yield highs (even for Limited, almost .3% difference) but no longer works now. Well, intermediate muni yields still came down *a lot* in the 1y time frame, but not short yields indeed.

So yes, Limited exceeded expectations by a lot this year. privateID: this is a phenomenon I explore in this thread: viewtopic.php?f=10&t=132601 . Like in that thread I remain skeptical of its ability to do so in the future; it just does not seem prudent to buy instruments yielding 0.9% on average (what each fund share you buy is made of) and hope that the fund's activities or a friendly yield curve allow it to make more. The SEC would certainly not be keen on funds saying so explicitly. So I stand by the recommendation to use a savings account instead. Or just go intermediate.
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Re: Sell Long term bonds with large gain for short term bond

Post by Kevin M »

stlutz wrote: Actually, the current SEC Yield of Limited Term Tax Exempt is .89%, which happens to be the *exact* same yield it had 1 year ago. Yet, in 2014 the *income* portion of this fund's return was 1.69%!
The income return was higher than SEC yield because distribution yield for this fund was consistently higher than SEC yield in 2014. This has been going on for years. I first pointed it out 3 or 4 years ago. Here for example:

Bogleheads • View topic - sec yield vs distribution yield
and here
Bogleheads • View topic - SEC Yield, Distribution Yield and NAV over 18 months

I explore this at some length here: Bogleheads • View topic - SEC Yield, YTM, Distribution Yield, Current Yield, and point out that this is analogous to the current yield of a bond being higher than the yield to maturity (YTM) of the bond.

For 2014, average distribution yield was 1.67%, which pretty much completely explains the income return. By contrast, average SEC yield was 0.83%. Here you can see graphically the stubborn persistence of a distribution yield premium during the 18 months for which Vanguard provides distribution yield data (and again, this has been going on for at least 3.5 years, since I first observed it and posted about it):

Image

I eliminated my position in Limited-Term Tax-Exempt when both SEC yield and distribution yield dropped below levels that were acceptable to me, but I was comparing to 5-year CDs with very small early withdrawal penalties (at the time, it was 60 days of interest at Ally), not to a savings account.

Yes, a savings account is different than a bond fund, and no, SEC yield may not be the best estimate of expected return over a period equal to average maturity (or duration, take your pick) of the fund. However, all fixed income can be evaluated in terms of credit/default risk and term risk. Both risks are essentially 0 for a savings account. Both are minimal, but definitely > 0 for Limited-Term Tax-Exempt. So no, we can't just compare SEC yield to APY and make a decision, but we can use them as part of the decision making process. I certainly do.

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Re: Sell Long term bonds with large gain for short term bond

Post by grabiner »

Since these are taxable bond funds, you will pay the tax cost from the capital gains one way or another. If you continue to hold the bonds, they will pay higher yields than the market rate, and that yield will all be taxable. Selling to pay the cost as a capital gain (instead of as ordinary income) makes sense, particularly since you don't want to hold the funds anyway.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

grabiner wrote:Since these are taxable bond funds, you will pay the tax cost from the capital gains one way or another. If you continue to hold the bonds, they will pay higher yields than the market rate, and that yield will all be taxable. Selling to pay the cost as a capital gain (instead of as ordinary income) makes sense, particularly since you don't want to hold the funds anyway.
That is a good point. One other point, however, is if these bonds are not sold and get inherited, you'd get the step-up basis. However, a few years of higher yields could certainly even that out.

So far they did sell the Long Term Invest-Gr (capital gains of $4k). They still have the 2 other long term bond funds (Long Term bond index, Long Term Treasury), TIPS fund and TBM.
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Re: Sell Long term bonds with large gain for short term bond

Post by saltycaper »

Not to sidetrack this thread, but can you clarify what you mean here, ogd? I thought you were referring to maturities/sales within the fund that result in taxable distributions, but then the second part of the statement makes me think I'm missing something because you seem to be referring to gains from sale of the fund itself.
ogd wrote:Bond capital gains don't accumulate for long term tax deferral, like they do for equities. I would probably wait for them become long term gains, though, if they're short right now.
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

saltycaper wrote:Not to sidetrack this thread, but can you clarify what you mean here, ogd? I thought you were referring to maturities/sales within the fund that result in taxable distributions, but then the second part of the statement makes me think I'm missing something because you seem to be referring to gains from sale of the fund itself.
ogd wrote:Bond capital gains don't accumulate for long term tax deferral, like they do for equities. I would probably wait for them become long term gains, though, if they're short right now.
What I mean if that if you look at a price chart of Total Bond Market, say, you see the price is fairly stable and range bound. For 30 years it stayed between $9 and $11. So whereas in a stock fund you'd be able to defer capital gains taxes for 30 years, in the bond fund they're not likely to last for even 5 years; instead, you'll eventually get them as interest.

I'm actually not sure why the price stays so stable even over a long period of interest rate declines; assuming it's tax regulatons that force the managers to eventually distribute the gains. The point is, the deferral is simply not as valuable. In stocks, the combination of deferral and growth works out the same as if you'd paid perhaps half or less of the capital gains rate every year, so deferral is worth quite a lot. Not so in bonds.
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Re: Sell Long term bonds with large gain for short term bond

Post by saltycaper »

ogd wrote:
saltycaper wrote:Not to sidetrack this thread, but can you clarify what you mean here, ogd? I thought you were referring to maturities/sales within the fund that result in taxable distributions, but then the second part of the statement makes me think I'm missing something because you seem to be referring to gains from sale of the fund itself.
ogd wrote:Bond capital gains don't accumulate for long term tax deferral, like they do for equities. I would probably wait for them become long term gains, though, if they're short right now.
What I mean if that if you look at a price chart of Total Bond Market, say, you see the price is fairly stable and range bound. For 30 years it stayed between $9 and $11. So whereas in a stock fund you'd be able to defer capital gains taxes for 30 years, in the bond fund they're not likely to last for even 5 years; instead, you'll eventually get them as interest.

I'm actually not sure why the price stays so stable even over a long period of interest rate declines; assuming it's tax regulatons that force the managers to eventually distribute the gains. The point is, the deferral is simply not as valuable. In stocks, the combination of deferral and growth works out the same as if you'd paid perhaps half or less of the capital gains rate every year, so deferral is worth quite a lot. Not so in bonds.
I see. Thanks. That is an interesting question regarding bond fund price stability.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

ogd wrote:
saltycaper wrote:Not to sidetrack this thread, but can you clarify what you mean here, ogd? I thought you were referring to maturities/sales within the fund that result in taxable distributions, but then the second part of the statement makes me think I'm missing something because you seem to be referring to gains from sale of the fund itself.
ogd wrote:Bond capital gains don't accumulate for long term tax deferral, like they do for equities. I would probably wait for them become long term gains, though, if they're short right now.
What I mean if that if you look at a price chart of Total Bond Market, say, you see the price is fairly stable and range bound. For 30 years it stayed between $9 and $11. So whereas in a stock fund you'd be able to defer capital gains taxes for 30 years, in the bond fund they're not likely to last for even 5 years; instead, you'll eventually get them as interest.

I'm actually not sure why the price stays so stable even over a long period of interest rate declines; assuming it's tax regulatons that force the managers to eventually distribute the gains. The point is, the deferral is simply not as valuable. In stocks, the combination of deferral and growth works out the same as if you'd paid perhaps half or less of the capital gains rate every year, so deferral is worth quite a lot. Not so in bonds.
So you're saying, purely from a taxes point of view, if I were to keep the bond funds for at least few years, then it would be better to sell long term bonds now because better to pay capital gains rates now instead of regular income over the next few years. Grabiner made the same point as well.

Did I get that correct?
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID wrote: So you're saying, purely from a taxes point of view, if I were to keep the bond funds for at least few years, then it would be better to sell long term bonds now because better to pay capital gains rates now instead of regular income over the next few years. Grabiner made the same point as well.

Did I get that correct?
Yes, basically. I am reluctant to draw a direct line between these capital gains and some amount of future interest, because like I said I am not familiar with all the regulations that make this happen. For one reason or another, in practice bond fund capital gains tend to disappear at a young age. Since the biggest advantage of capital gains is long-term deferral (particularly in the "decades" time frame), you simply don't care for them much in bond funds. Now vs a few years later does not make much of a difference.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

ogd wrote:
privateID wrote: So you're saying, purely from a taxes point of view, if I were to keep the bond funds for at least few years, then it would be better to sell long term bonds now because better to pay capital gains rates now instead of regular income over the next few years. Grabiner made the same point as well.

Did I get that correct?
Yes, basically. I am reluctant to draw a direct line between these capital gains and some amount of future interest, because like I said I am not familiar with all the regulations that make this happen. For one reason or another, in practice bond fund capital gains tend to disappear at a young age. Since the biggest advantage of capital gains is long-term deferral (particularly in the "decades" time frame), you simply don't care for them much in bond funds. Now vs a few years later does not make much of a difference.
Thanks for the responses. They really help.

Do you think this point is true across all bonds: Long/int/short, muni/treasury/corporate, nominal/inflation?

Just looking at some of the prices, it seems not all bonds have as tight a nav as TBM. I probably would need to study it a bit, though, to really understand.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

The more I think about this, isn't this just normal bond pricing. Assume for a moment a fund has only one bond in it, for a term of 10 years and it cost $100. If rates drop, the price of the bond goes up. Let's say it goes to $150. If nothing else changes for 10 years, the price of the bond fund will slowly go back to $100 as the value changes with less interest payments to receive. Even if rates change, the value will still go to $100. A fund that has many bonds really works similar except that there's always new bonds in it. But the number of bonds in it does not fluctuate too much.

Bonds have always made my head spin, so I could be way off here, but it does explain what we're talking about.
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID wrote: Do you think this point is true across all bonds: Long/int/short, muni/treasury/corporate, nominal/inflation?

Just looking at some of the prices, it seems not all bonds have as tight a nav as TBM. I probably would need to study it a bit, though, to really understand.
I can't say I've looked at all of them, but I don't remember any fund that appeared to have price/capital gains growing to infinity. If I so, I would probably own it (if it was taxable -- for munis you want the opposite, high interest and capital losses).

Note that long funds and credit risky funds will have a much larger range, since they can have a lot of volatility in the short term. Still, it seems to be a range.
privateID wrote:The more I think about this, isn't this just normal bond pricing. Assume for a moment a fund has only one bond in it, for a term of 10 years and it cost $100. If rates drop, the price of the bond goes up. Let's say it goes to $150. If nothing else changes for 10 years, the price of the bond fund will slowly go back to $100 as the value changes with less interest payments to receive. Even if rates change, the value will still go to $100. A fund that has many bonds really works similar except that there's always new bonds in it. But the number of bonds in it does not fluctuate too much.
Yes, that's definitely part of it. However, many funds would sell the bond relatively quickly while it's still appreciated, long before maturity. If they were able to get rid of realized capital gains (e.g. through the ETF redemption process), they could keep on appreciating. It might be simply a matter of scale, a lot more realization of gains than can be disposed of, way more than in a stock fund because of the bonds' naturally high turnover requirements (they become unsuitable for a specific fund as time passes). Note that large-ish capital gains distributions (realized gains) are definitely happening for some of these funds. Same conclusion for these though -- the gains you realized today might have been distributed in a year or two anyway, so no long-term deferral.
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Re: Sell Long term bonds with large gain for short term bond

Post by Kevin M »

One obvious reason price has been somewhat range-bound with falling rates is capital gains distributions. Price difference adjusted for cap gains distributions is larger.

Adjusted price for TBM (VBMFX) shown on YahooFinance is $1.89 on Dec 11,1986. However, I don't know that this is the correct price adjustment for Vanguard funds like VBMFX, because accrued dividends are not reflected in price before distribution as with some funds, but are accrued daily in the shareholders' accounts (you can see your accrued dividends increasing daily as a separate dollar amount). Still, if we adjusted only for capital gains, adjusted price in 1986 would be lower by amount of total capital gains distributions since then.

One exception to the range-bound thing, but in the other direction, is the VG high yield fund. Unadjusted price in 1980 was 9.54, and price now is 5.97, so almost 40% lower. I believe it's been pointed out that this is typical of high-yield bond funds, since essentially part of the high yield is at the expense of capital loss due to defaults.

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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

Kevin M wrote:One exception to the range-bound thing, but in the other direction, is the VG high yield fund. Unadjusted price in 1980 was 9.54, and price now is 5.97, so almost 40% lower. I believe it's been pointed out that this is typical of high-yield bond funds, since essentially part of the high yield is at the expense of capital loss due to defaults.
An interesting case, Kevin. With very safe bond funds you could argue that maybe it's the managers' preference to keep the price stable. But the case of the high yield fund and its (expected rate of) defaults shows that they are actually unable to accumulate capital gains even to the relatively small degree of countering defaults. So it must be tax regulations that force them to distribute / yield almost all of their return.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

Thanks for all the responses. They have helped.

So at this point I've convinced myself to sell the long-term bond funds. I really had no desire for them to hold them and it seems like paying the capital gains now will even out pretty soon with lower interest payments.

So now I'm left to think about the two other bond funds: TBM and TIPS. They are both being held in taxable accounts. These two funds I have no problem holding (meaning I like these funds). However, they are clearly not tax-efficient. Do you guys think it's in the best interest to sell these funds and buys munis in the 28% tax bracket? These bond funds can be bought in an IRA if they are desired to be kept.
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID: I would order the choices like this:

Best: taxable bonds or bank CDs in IRA.
Good: munis in taxable.
Not too bad: taxable bonds in taxable. I estimate that the tax bracket that makes munis "worth it" is about 25%, so you're not too far above that.
Good alternative: bank CDs in taxable. I would probably prefer these to munis right now in the 28% at least for some portion of the funds.

I would only hold TIPS if this is a high fixed income portfolio close to retirement. For this particular piece of advice, you might want to post a full portfolio review thread.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

Thanks again for the help. I did sell some of those bond funds.

I was curious if the same principal would be true for REIT funds (capital gains eventually get dispersed as income over time)? It would make sense to me that REITs, which we know have to distribute a certain percentage of gains every year, would have this same exact situation.

Thoughts?
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Re: Sell Long term bonds with large gain for short term bond

Post by Kevin M »

REITs are a completely different animal. They are much more volatile than intermediate-term bonds, and can have much larger capital gains and losses than intermediate-term bonds. We've had days where Vanguard REIT fund went up or down about 10%, and REITs are up almost 30% in the last year. Easy to verify by looking at some price history or growth history charts.

EDIT: as of this moment, Vanguard REIT ETF (VNQ) is almost 31% above its 52-week low. VG total bond ETF (BND) is about 3.6% above its 52-week low. Long-term bonds are more volatile of course. VG Long-Term Government (VGLT) is about 24% above its 52-week low.

EDIT2: In last 15 years, Vanguard REIT fund investor shares (VGSIX) price (not adjusted for any cap gain distributions) is up about 180%, Long-Term Investment Grade bond fund is up about 36%, and Long-Term Treasury fund is up about 40% (according to Google Finance).

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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID wrote:Thanks again for the help. I did sell some of those bond funds.

I was curious if the same principal would be true for REIT funds (capital gains eventually get dispersed as income over time)? It would make sense to me that REITs, which we know have to distribute a certain percentage of gains every year, would have this same exact situation.

Thoughts?
Nope -- REITs are only required to distribute the income. The other component, the appreciation of real estate, accumulates over time.

Like Kevin says, they are like stocks not like bonds. Not always correlated, but definitely stock-like. In a crash, both real estate value and rental income will be casualties. A safe bond resists the crash because both the coupons and the principal are guaranteed.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

You guys respond fast.

So if a REIT fund exists in a taxable account, with a decent amount of gains, any suggestions about what to do about it? Ideally, the fund would be held in a tax-advantaged account unless the income was needed (which is not the case).
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Re: Sell Long term bonds with large gain for short term bond

Post by Kevin M »

And REIT correlation to stocks and bonds changes over time. Very recently, REITs have been up on most days when most other stocks are down. In 2000-2002, REITs went up when broad US market went down. From 2000-2007 REITs absolutely killed broad US stock market. But then of course in 2008, REITs were devastated much worse than broad US stock market. If you were lucky enough to rebalance into REITs in early March 2009, you have been rewarded handsomely.

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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID wrote:You guys respond fast.

So if a REIT fund exists in a taxable account, with a decent amount of gains, any suggestions about what to do about it? Ideally, the fund would be held in a tax-advantaged account unless the income was needed (which is not the case).
Sell all of it as soon as gains are long term (if not already), buy in tax-advantaged if desired for your allocation. REITs are absolutely toxic in taxable.

Personally, I don't hold any since I hold more house than I'm comfortable with from a purely investment perspective. Needless to say, there are other perspectives :mrgreen:
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Re: Sell Long term bonds with large gain for short term bond

Post by Kevin M »

privateID wrote: So if a REIT fund exists in a taxable account, with a decent amount of gains, any suggestions about what to do about it? Ideally, the fund would be held in a tax-advantaged account unless the income was needed (which is not the case).
Fortunately, I "moved" my REIT fund from taxable to tax-advantaged some years ago.

What I do is have a a policy target allocation to my REIT fund, and rebalance when either the upper or lower limit of the rebalancing band is triggered. Obviously better in a tax-advantaged account. In a taxable account, might make the rebalancing band wider, and be sure not to sell any shares for which gains are short term. Short term losses are fine (even preferable to long-term losses).

Is there a policy allocation to REITs? Better to have a policy and stick to it than figure these things out on the fly. So if no policy, I'd give it some thought and establish one.

I have an absolute dollar target for my REIT fund (not typical, but it's what I do for this fund). Current rebalancing band is +15%/-20% of target value. It was +25%/-10%, but due to some very reasonable postings on high REIT valuations by the likes of William Bernstein awhile back, I adjusted my band down, as I posted for example here: Bogleheads • View topic - Rebalancing Band for an asset class based on volatility (My IPS basically is what I post on Bogleheads). Contrary to that wisdom, REITs have performed spectacularly over the last year, I've already rebalanced out (back to target) once since changing my band limits, and am more than halfway to the upper rebalancing limit already since then.

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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

Slowly getting to to my goals. Re-reading the responses, I believe I omitted a relevant piece of information. The questions in this thread are in regard to a retired relative.

Current situation:

1) Sold most of the bond funds that had a capital gain. Replaced them with desired bond funds.

2) Decided NOT to sell REIT fund. Although the income is not necessary, there does not seem to be a huge advantage to selling them. If REITs are desired anyhow, then paying ordinary dividends in the form of RMDs from an IRA is the same as in taxable. Also, although the income is currently not needed, one never knows in the future.

3) Still deciding on whether to sell one last bond fund: TIPS fund. Any special consideration for a TIPS fund versus the other bond funds? Assuming holding some TIPS is desirable, and the income is not currently needed, any benefit to selling them in taxable and correspondingly shifting some IRA money TIPS?

Thanks for the continued help
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

It seems to me that TIPS funds have a decent amount of volatility. My current thinking is not to sell them. Especially because there are state taxes to be concerned about.
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Re: Sell Long term bonds with large gain for short term bond

Post by larmewar »

I prefer individual TIPS to TIPS funds. TIPS bought at auction have no transaction cost and 0 BP ER.

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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

larmewar wrote:I prefer individual TIPS to TIPS funds. TIPS bought at auction have no transaction cost and 0 BP ER.
Lar
I generally do too, but that's not the situation. The TIPS fund is already owned and has some capital gains. I'm trying to figure out whether to sell them (and then move some tax-deferred space to TIPS) or leave them in taxable. I guess I could sell them and buy individual TIPS in either location too.

The more I think about it, the state tax advantage makes a TIPS fund more tax-efficient than many other bonds. For this reason I'm leaning toward keeping them unless I'm convinced that capital gains will be distributed as income making it better to realize the capital gains.
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID wrote: 2) Decided NOT to sell REIT fund. Although the income is not necessary, there does not seem to be a huge advantage to selling them. If REITs are desired anyhow, then paying ordinary dividends in the form of RMDs from an IRA is the same as in taxable. Also, although the income is currently not needed, one never knows in the future.
This isn't a good rationale for holding REITs in taxable. It's true that you will eventually pay income taxes on their growth in tax-deferred, but you pay those on any kind of growth, whereas in taxable you can pay much less on certain kinds of growth, most importantly stocks. So it makes sense to hold in taxable those funds that are tax efficient (where it makes a difference), holding the rest in tax deferred.

Saying you pay ordinary income taxes on everything you hold there also makes it sound like tax deferred accounts are not even a good idea. But they are, because the income never got taxed going in. IMHO the best way to think about this is that the government "owns" 25% of that account, and you pay no taxes at all on your 75%, which clarifies the problem at hand among other things. For more details see https://www.bogleheads.org/wiki/Princip ... _placement and https://www.bogleheads.org/wiki/Tax-adj ... allocation . Note how low REITs are on the tax efficiency scale -- I would never hold them in taxable.

In general, don't worry about income specifically. It can be topped up through sales if needed -- even if the asset to be sold is in an unavailable IRA, one can always simulate the sale of asset A by selling the asset B that's in taxable then exchanging asset A for asset B in the tax deferred acount. This leaves the portfolio in the same place as if asset A had been held & sold in taxable, except with less taxes (on asset B) until then of course.

What's important is that the portfolio's total return is enough to support the withdrawals.
privateID wrote: 3) Still deciding on whether to sell one last bond fund: TIPS fund. Any special consideration for a TIPS fund versus the other bond funds? Assuming holding some TIPS is desirable, and the income is not currently needed, any benefit to selling them in taxable and correspondingly shifting some IRA money TIPS?
If you want to hold TIPS at all (see above for my considerations -- high fixed income % close to retirement), they too are best held in a retirement account. One interesting note with TIPS is that their inflation-tracking guarantees are weakened by taxes and high inflation can hurt via taxes even if short-lived (see: https://www.bogleheads.org/wiki/Treasur ... iderations).

Glad you're getting things moving!
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

ogd - I have very much appreciated your posts in this thread. I understand your comments and agree with them in general. Just trying to figure out if they apply to this situation.

Let me give a bit more information. I haven't been concealing information on purpose, just trying to focus the conversation without muddying the waters. The relative is 80 years old. We decided together to use a 40% stock/60% bond asset allocation. She is in good health. All of her tax-deferred money is invested in bond funds.

REITs - If we were to shift tax-deferred money to REITs, then would need to shift the taxable REITs to bonds to keep the AA. So, we wouldn't be moving more tax-efficient stocks into taxable. That is why I thought that continuing to hold them in taxable is ok (combined with my other reasons). I fully understand the point about the gov't owning about a third of the account (fed+state), but there is already all tax-inefficient items in there, RMDs are being taken every year and no new contributions are being made.

TIPS - Since there is already all bonds in the tax-deferred, it just seems like if TIPS will be held, there are actually more tax-efficient (due to state tax savings) than the bonds currently being held in tax-deferred. I decided to sell the other bond funds because I believe (partly due to your input) that it will only take a few years to make back the cost of the capital gains being paid. In the other bond cases, I also preferred to own a different bond fund (not totally true for TBM, but for the most part true for what was sold). Just not sure if the same dynamic is present with TIPS - Are those capital gains converted to income over the years? Given the fact that I want some TIPS held, does that change things a bit? Does the saving of state taxes change things a bit? My current thinking to the answers (mostly yes) have lead to believe I should not sell the current allocation of TIPS in taxable.

Obviously, things are different when constructing a portfolio from scratch. I'm just make the best of a situation for an elderly relative.

Thanks
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Re: Sell Long term bonds with large gain for short term bond

Post by grabiner »

privateID wrote:REITs - If we were to shift tax-deferred money to REITs, then would need to shift the taxable REITs to bonds to keep the AA. So, we wouldn't be moving more tax-efficient stocks into taxable.
There is still a tax advantage for holding REITs in the tax-deferred account, even if yields are equal. If you hold $100K in a taxable bond fund with a 3% yield, you owe taxes on $3K, regardless of how much you spend from the fund; you can sell bonds beyond $3K with little or no capital gain. If you hold $100K in a REIT fund with a 3% taxable yield plus 1% return of capital, you receive a $4K distribution, and if you sell anything beyond that (now or in a later year), you owe capital-gains tax as well as tax on the $3K distribution.

If she holds TIPS (or other Treasury bonds), they are a good choice for a taxable account, both because of the state tax exemption and because Treasuries have lower yield than other bonds.
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Re: Sell Long term bonds with large gain for short term bond

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grabiner wrote:
privateID wrote:REITs - If we were to shift tax-deferred money to REITs, then would need to shift the taxable REITs to bonds to keep the AA. So, we wouldn't be moving more tax-efficient stocks into taxable.
There is still a tax advantage for holding REITs in the tax-deferred account, even if yields are equal. If you hold $100K in a taxable bond fund with a 3% yield, you owe taxes on $3K, regardless of how much you spend from the fund; you can sell bonds beyond $3K with little or no capital gain. If you hold $100K in a REIT fund with a 3% taxable yield plus 1% return of capital, you receive a $4K distribution, and if you sell anything beyond that (now or in a later year), you owe capital-gains tax as well as tax on the $3K distribution.

If she holds TIPS (or other Treasury bonds), they are a good choice for a taxable account, both because of the state tax exemption and because Treasuries have lower yield than other bonds.
Thanks for your input Grabiner. I have always appreciated your posts.

Just to be clear, given the info I have supplied, you would recommend selling the REITs from the taxable but keeping the TIPS in the taxable. Correct?

Is there any circumstance where you think it would make sense to keep the REITs in taxable? What if the income from the REITs were needed? What if I'm pretty sure nothing more would need to be sold and eventually whatever was left would be inherited?

In the other cases, I was pretty convinced to sell the taxable bonds. I'm still not convinced for these last two items. I thing I'm convinced to keep the TIPs in the taxable. Still thinking about the REITs.
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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID wrote: REITs - If we were to shift tax-deferred money to REITs, then would need to shift the taxable REITs to bonds to keep the AA. So, we wouldn't be moving more tax-efficient stocks into taxable. That is why I thought that continuing to hold them in taxable is ok (combined with my other reasons). I fully understand the point about the gov't owning about a third of the account (fed+state), but there is already all tax-inefficient items in there, RMDs are being taken every year and no new contributions are being made.
privateID: you're certainly welcome.

I see about the tax-advantaged accounts full of bonds. Then it makes more sense, but still there are better options: bonds in taxable, particularly munis or Treasuries, are still not as tax-inefficient as REITs. The second option is simply other stocks, without holding REITs at all; note that REITs are equity-like, despite the income. If you imagine other holders of REITs pricing them in comparison to other stocks, myself for example, I would bet that most of them are holding them in tax-advantaged and probably pricing them more richly than their return to you would warrant. In other words, in your specific situation REITs compared to other stocks are a bad deal because of a 28% hit to a big chunk of their return. Do not get hung up on income return vs total return, but if you do want income e.g. to simplify things for your relative, high dividend stocks still have much better tax treatment than REITs.

(NB: I don't hold REITs anymore, but I did before buying a home. Definitely in tax-advantaged, even though it meant more bonds in taxable).
privateID wrote: TIPS - Since there is already all bonds in the tax-deferred, it just seems like if TIPS will be held, there are actually more tax-efficient (due to state tax savings) than the bonds currently being held in tax-deferred. I decided to sell the other bond funds because I believe (partly due to your input) that it will only take a few years to make back the cost of the capital gains being paid. In the other bond cases, I also preferred to own a different bond fund (not totally true for TBM, but for the most part true for what was sold). Just not sure if the same dynamic is present with TIPS - Are those capital gains converted to income over the years? Given the fact that I want some TIPS held, does that change things a bit? Does the saving of state taxes change things a bit? My current thinking to the answers (mostly yes) have lead to believe I should not sell the current allocation of TIPS in taxable.
Given your additional information, I agree that TIPS are one of the better things to hold in taxable and that the situation probably warrants holding a good amount of them. No reason to sell then.

Also remember the CD alternative. The yields are enough higher than bonds to make up for state tax and/or muni tax savings. From my experience helping non-savvy relatives of my own, they love CDs. If you can piggyback on an existing bank relationship, or open a single bank account (I recommend Barclay's because they've stayed competitive for years now so you don't have to switch around), it shouldn't complicate things that much either.
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Re: Sell Long term bonds with large gain for short term bond

Post by grabiner »

privateID wrote:Just to be clear, given the info I have supplied, you would recommend selling the REITs from the taxable but keeping the TIPS in the taxable. Correct?
This is correct. Particularly with current rates, TIPS aren't bad in a taxable account.
Is there any circumstance where you think it would make sense to keep the REITs in taxable? What if the income from the REITs were needed?
This is a psychological issue, not a tax issue. You can spend distributions, or sell investments to raise more money. Most stocks retain most of their income, paying out only a small amount in dividends, so that the value grows. REITs are required to pay out almost all of their net income, and some of the dividend is a return of capital; thus, if you spend the whole distribution, your investment still shrinks because of the return of capital.
What if I'm pretty sure nothing more would need to be sold and eventually whatever was left would be inherited?
In that situation, REITS and taxable bonds with equal taxable yield are equally tax=efficient, as the capital gains on the REITs are irrelevant. REITs are still less tax-efficient than lower-yielding bonds, such as Vanguard REIT Index versus Total Bond Market.
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Re: Sell Long term bonds with large gain for short term bond

Post by privateID »

Thanks. I'm pretty much convinced not to sell the TIPS funds. Still have some thoughts about the REITs based on the comments.

I believe what you guys are saying is that REITs are so tax-inefficient because they have stock-like returns (stocks have larger returns), but since most of the dividends (including the return on capital) do not qualify for QDI, most of the large return is taxed at ordinary tax rates. Bond funds, on the other hand, also do not qulaify for QDI. However, since the returns are lower, they are more tax-efficient than REITs. Long-term bond funds are more similar to REITs, in this respect.

So, if the REIT fund is sold now, the $3K gain will be capital gains. The money can be used for something more tax-efficient. If the REIT fund is not sold now, she will potentially have years of stock-like returns that do not qualify for QDI.

This sounds to me like in the accumulation phase, it really does not make sense to hold REITs in taxable. In the distribution phase of life, if the income is not needed, it also sounds like it is a bad idea to hold REITS in taxable. However, in the distribution phase, if the income is needed, then I'm still trying to understand if holding REITs in taxable is bad. It's almost like a super bond fund in that you can hold a smaller amount than other bond funds, yet receive more income. One negative may be the volatility, where the income received varies quite a bit from year to year. So that perhaps adds another caveat. So how about this statement:

If one is in the distribution phase, and one needs the income but does not need the income as a consistent income stream, then holding REITs in taxable is no worse than other bond funds.

Sometimes I like to push things to an extreme in an effort to better understand them. That is why I'm trying to figure out under what circumstances it does make sense to hold REITs in taxable.
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Re: Sell Long term bonds with large gain for short term bond

Post by Kevin M »

^Much of this analysis may make sense, but here are a few comments.

I believe dividend yield on REITs is not particularly high relative to historical yields. Also, some pundits have been saying that REIT valuations are historically high, so expected return on REITs is historically low. On the other hand, that was being said a year ago, and the 1-year return of the Vanguard REIT fund is about 30%.

At least 25 percentage points of the 1-year 30% return is from capital appreciation. Keep in mind that gain on shares held for less than one year is taxed at regular federal rates.

For what it's worth, almost 80% of my total return on my REIT fund since March 2010 is from capital appreciation. This is consistent with the last year, for which at least 25/30 = 83% was from capital appreciation.

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Re: Sell Long term bonds with large gain for short term bond

Post by ogd »

privateID: REITs are not bonds. They are incomparably more risky. In 2008 the REIT index declined as much as 60%. They should be considered equities, alternatives to the equity allocation.

It's unfair to compare them to bonds and say they have this extra return that's more tax efficient (capital gains). That's at the cost of a lot of extra risk, and in an apples-to-apples comparison (portfolios of the same risk) it would need to be compensated by a reduction in the equity allocation, costing more tax efficiency than you gain from said capital gains.

In other words, your alternative is not "replace REITs with bonds". The alternatives are:

1) Replace REITs in taxable with equities, high-dividend if need be. This is more tax efficient because of QDI.
2) Displace bonds from tax-advantaged. This displacement occurs on a dollar-per-dollar basis of capital, not return. So you need to look at the tax cost of $1000 of bonds vs REITs, and bonds will have lower costs presently and for a long time to come. You can't look at the cost of $1000 of return, because you can't switch REITs returning $1000/yr with bonds returning $1000/yr, but maybe only $300/yr.

Hope this makes sense. Again, I would never consider REITs in taxable even if it meant having none at all.
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