Keep Your Bondholding Productive

11/23/2011 10:00 am EST

Focus: BONDS

Marilyn Cohen

President & CEO, Envision Capital Management, Inc.

Although we count on bonds to be relatively steady long-term investments, it’s important to evaluate your holdings when markets get volatile, writes Marilyn Cohen of Bond Smart Investor.

Those of us who live on the West Coast prepare for earthquakes with our candles, flashlights, extra water, and MREs. People in the Gulf Coast states have their hurricane warning systems, basements for shelter, and provisions aplenty.

Those in Tornado Alley run to their well-stocked basements and root cellars for safety. And people on the East Coast prepare for those ever-so-cold winters with snow shovels, snow plows, and well-provisioned larders. We all have our fallback positions in case Mother Nature shows her angry rage, as we’ve seen so many times this year.

Well, it’s important to insulate your bond portfolio from the market’s volatile rage. It comes in many forms: Bonds implode (as did MF Global), and markets change direction, as we experienced with high-yield corporate bond spreads blowing out in August and part of September, only to wickedly contract back.

Whether the emergency is natural or man-made, preparation and execution count. As the year quickly winds down, it’s important to prepare for the man-made disaster called the IRS Code. If not prepared, it can be a hurricane to your financial well-being, leaving a trail of debris in its wake.

The easiest preparation is to harvest your capital losses and offset them with gains. Many of you own TIPS and TIP funds. Bravo! You’ve had a great run.

Treasury Inflationary Securities maturing from one to ten years are trading at negative yields. How much more juice is there? Take some of those profits off the table and book them against your losses.

The same thing goes for munis. Many of your individual municipal bond funds are trading at higher prices than you bought in for.

It’s no sin to lock in some profit. That doesn’t mean you need to exit the sector. It only means that you should seize the opportunity to book your capital gains and offset them against losses elsewhere in your portfolio.

Switch from a closed-end fund to open-end. Sell your open-end fund and replace it with individual munis. Save yourself from the tax man.

For those of you who have purchased several of our corporate-bond recommendations priced at premiums over par value—and now hold them outside of your tax-deferred accounts—amortize the premiums against income the bonds generated.

Take the amortized premium as a deduction now rather than waiting until the bonds mature. Most investors book the premium erosion as a capital loss.

However, you will likely have to take the initiative with your tax accountant for this amortization treatment. Most prefer capitalizing the bond premium at maturity. It’s easier and less work for the accountant, since at maturity, the numbers are laid out in the Form 1099s sent by the brokerage firms.

However, taking the easy way out often doesn’t maximize tax benefits on taxable bonds that you purchased at a premium.

Let’s say you have hefty gains in Ford (F) bonds that you purchased at a discount when Ford was in the financial intensive-care ward. And you still believe, as we do, that Ford will soon gain investment-grade status.

If you have outsized gains in Ford bonds and losses in equities, then swap your Ford bonds into another Ford bond issue with a different coupon and/or maturity. Or ask your broker to sell the bond and simultaneously buy it back. There are no wash-sale rules prohibiting the taking of profits. Wash-sale rules apply only to losses.

As we advise with all our recommendations, be prepared for 100-year flood type of events. Do this by taking no more than a maximum 3% to 5% allocation in any one bond position. This way, when things go south and a bond gets nuked, the loss won’t be life-threatening. Your shelter is your carefully allocated positions.

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