The Right Asset. In the Right Place. At the Right Time

By Lucas Felbel, CIMA®, Director, Portfolio Services

Financial advisors stand as fiduciaries dedicated to advocating for client interests and refining their expanding knowledge library, directly benefiting their clientele. Cornerstone to an advisor’s fiduciary insight lies in optimizing post-tax investment outcomes through strategic asset placement across designated accounts, termed asset location. Prioritizing asset location not only enhances the value of an advisor’s services but also distinguishes advisors from competitors. Intentional asset location not only offers clients more opportunities for superior after-tax returns but also enriches the advisory experience.

Portfolio Perspectives recently explored the benefits of equity asset location, delving into nuanced strategies for advisors seeking to elevate investment performance while navigating client tax efficiency. Equally vital in the asset location conversation is the ideal placement of individual bonds and other fixed income instruments in taxable, tax-deferred, and tax-exempt accounts. Like most intricate concepts, asset location involves both advantages and drawbacks, which this article aims to explain, promoting heightened advisor awareness in refining their clients’ fixed income investment outcomes and overcoming potential challenges.

Investment Grade Corporate Bonds

When discussing “bonds,” investment-grade corporate bonds typically come to mind as the predominant fixed income type. These debt instruments, issued by highly-rated public companies, are secured by the creditworthiness of the issuer and traditionally yield higher coupon/interest payments compared to federal or municipal bond issues. While higher yield generates increased income for the holder, it is important to consider the tax treatment of this income. Interest income from corporate bonds is fully taxable at ordinary income levels (both federally and at the state level), potentially wielding a significant impact on client tax profiles if held in taxable accounts.

Savvy advisors are cognizant of clients’ tax situations and may opt to direct higher-yielding taxable fixed income investments to tax-deferred or tax-exempt accounts, depending on circumstance. Nonetheless, in today’s interest rate environment for clients nearing retirement and anticipating substantially lower taxable income levels in the future, strategically placing investment-grade corporate bonds, with yields exceeding 5%, in taxable accounts may prove advantageous. In this scenario, clients would benefit from maturing bonds furnishing substantial portions of their income needs while generating interest income levels not experienced in decades. Additionally, effective use of taxable accounts for living expenses extends the lifespan of tax-deferred and tax-exempt retirement accounts increasing flexibility in clients’ wider financial plans. Advisors should continually explore creative solutions to capitalize on unique client circumstances within current market and interest rate environments.

Treasury Securities and other Federal Government Obligations

Amid the current economic landscape, investors may find it challenging to identify a more compelling short-term security than fixed income instruments from the US Treasury. Conventionally, treasury securities are viewed as a safer alternative to investment grade corporate bonds with investors typically accepting lower yields for the security provided by the US government. However, in recent years, shorter term treasuries have exhibited robust yields, often comparable to those offered by similar term high-quality corporate bonds.  Importantly, this assessment does not yet account for the tax-equivalent yield to investors, as income from treasury securities is typically not taxed at the state or local level, only federally.

For advisors contemplating tax ramifications of treasury securities for their clients, the potential after-tax benefits are realized even more-so by clients residing in high tax bracket states (e.g., New York, New Jersey, California, Hawaii, etc.). In such cases, holding these securities in taxable accounts may offer additional after-tax advantages compared to less tax-efficient corporate bond income taxed at the client’s resident state levels.

Municipal Bonds

Like the federal government, municipalities across the United States issue fixed income securities to fund community development projects, often at more modest interest rates. To incentivize investors choosing municipal bonds with lower yields, income received from municipal bonds is typically only taxed at the local state level, exempting it from federal taxation. Moreover, if an investor resides in the state that issued the bond, income received is often tax-free at both state and federal levels.

You read that correct – if an investor resides in the same state as the municipal bond was issued, income received is tax-free (in most cases).

For clients with high income levels in states with high income taxes, municipal bond portfolios present an excellent solution for taxable accounts, generating tax-free income and allowing clients to assume additional risk in tax-deferred and tax-exempt accounts. Conversely, clients residing in states without income tax may benefit from exploring higher-yielding municipal bonds from other states while still retaining federal tax-exempt income status.

Advisors should steer clients away from considering municipal bond portfolios for tax-deferred or tax-exempt accounts as these account types negate the after-tax return benefits of municipal bonds.  Deployment of municipal bonds in this manner will likely disadvantage clients. Taxable bond assets should instead be prioritized for tax-deferred and tax-exempt account types.

Final Thoughts

When evaluating municipal bonds, corporate bonds, and federal government obligations, the choice of asset allocation across different accounts and situations should heavily integrate the tax suitability of each client’s unique circumstances. Unfortunately, this is often overlooked by advisors when determining suitability of fixed income portfolios. To aid in selecting a suitable client bond portfolio, advisors must pay close attention to a concept called tax equivalent yield. This metric “levels the playing field” in terms of tax benefits, enabling advisors to conduct a more comprehensive analysis of client suitability for various debt instruments.

Tax Equivalent Yield = (Tax Free Yield / 1 – Client’s Tax Rate)

When selecting an appropriate fixed income solution for clients, advisors must draw upon a meticulous collection of client information capturing the entirety of the financial situation, as well as the vast investment solution and education resources at their disposal. The asset management team at Dynamic has engaged in numerous such discussions over the years, regularly assisting advisors in identifying opportunities to achieve superior fixed income investment outcomes and executing them to realization.

Invest with Intention.

This article is not exhaustive, and specific advice should be sought from qualified tax professionals before implementation.

For more information, contact Dynamic’s Investment Management team at (877) 257-3840, ext. 4 or investmentmanagement@dynamicadvisorsolutions.com.

As Director, Portfolio Services, Lucas Felbel, CIMA®, leads the implementation, monitoring and evaluation of trading activities at Dynamic Advisor Solutions.

Disclosures

This commentary is provided for informational and educational purposes only. The information, analysis and opinions expressed herein reflect our judgment and opinions as of the date of writing and are subject to change at any time without notice. This is not intended to be used as a general guide to investing, or as a source of any specific recommendation, and it makes no implied or expressed recommendations concerning the manner in which clients’ accounts should or would be handled, as appropriate strategies depend on the client’s specific objectives.

This commentary is not intended to constitute legal, tax, securities or investment advice or a recommended course of action in any given situation. Investors should not assume that investments in any security, asset class, sector, market, or strategy discussed herein will be profitable and no representations are made that clients will be able to achieve a certain level of performance, or avoid loss.

All investments carry a certain risk and there is no assurance that an investment will provide positive performance over any period of time. Information obtained from third party resources are believed to be reliable but not guaranteed as to its accuracy or reliability. These materials do not purport to contain all the relevant information that investors may wish to consider in making investment decisions and is not intended to be a substitute for exercising independent judgment. Any statements regarding future events constitute only subjective views or beliefs, are not guarantees or projections of performance, should not be relied on, are subject to change due to a variety of factors, including fluctuating market conditions, and involve inherent risks and uncertainties, both general and specific, many of which cannot be predicted or quantified and are beyond our control. Future results could differ materially and no assurance is given that these statements or assumptions are now or will prove to be accurate or complete in any way.

Past performance is not a guarantee or a reliable indicator of future results. Investing in the markets is subject to certain risks including market, interest rate, issuer, credit and inflation risk; investments may be worth more or less than the original cost when redeemed.

Investment advisory services are offered through Dynamic Advisor Solutions, LLC, dba Dynamic Wealth Advisors, an SEC registered investment advisor.

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