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Long Term Capital Gain Arbitrage - ETF Bond Funds
08-14-2020, 12:05 PM
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#1
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Recycles dryer sheets
Join Date: Jul 2017
Location: Southern California Area
Posts: 99
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Long Term Capital Gain Arbitrage - ETF Bond Funds
So, like many people, I am sitting on large gains in my ETF bond funds (VCIT and USIG), as interest rates have steadily moved downward over the last several months. Because I bought these funds many years ago, they are long-term capital gains.
If would seem that if I continue to hold these, and interest rates stay where they are, that my long term capital gain will be burned down over time (theoretically over the average duration, say 7 years) with higher than market interest dividends.
GIven that interest dividends are taxed at maximal federal rates of like 39%...it would seem to make more sense to sell these funds, and incur those gains now at the long-term capital gain rate, which would save me taxes.
I'm itching to do this..but I'm also thinking I might be missing something obvious. Has anyone else considered this strategy or have any ideas on what I might be missing?
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08-14-2020, 12:31 PM
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#2
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Nov 2010
Location: Sarasota, FL & Vermont
Posts: 36,201
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I'm not sure it will sugar off as you think it will. For the purpose of thinking about this I'm assuming that interest rates stay flat for a long time.
Any unrealized gains in the underlying bond portfolio will decay as the bonds mature and be reinvested at lower interest rates, but will not impact the cash flows of the portfolio so it won't impact the funds future dividends at all.
If rates stay the same and all interest were distributed and maturities reinvested, eventually the NAV would drift to the par value per share of the underlying bond portfolio.
So let's say that the par value per share today is 100 and the fair value per share is 120 and the average coupon is 4% and market yield is 1% . Eventually, the 120 will drift down to 100. If you bought the fund today you would pay 120 and receive higher than market interest distributions based on a 4% coupon partially offset by the amortization of premium from 20 to zero.... so your total return would be the 1% market yield. As a fund holder, your amortization of premium is the decline in the NAV that you can later realize when you sell and get a tax benefit.
To be fair there are many moving part in reality, but from the 100,000 foot level....
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08-14-2020, 12:54 PM
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#3
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Recycles dryer sheets
Join Date: Jul 2017
Location: Southern California Area
Posts: 99
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Thank you pb4uski....I follow your math and examples, and agree that's how the decay would work. My question is...given that...wouldn't it make sense to sell the funds now, and get that "extra" above market dividend early in the form of a realized capital gain...and thus pay long term capital gain tax rate today (I have held the ETF's for a few years) rather than the regular income tax rate over time? Given capital gain tax rate is 20%, vs. my marginal 39% tax rate, it would seem to be a winner even when considering the time value of money...but it seems too simple that I might be missing something obvious.
To be clear, the reason I am sitting on a long term capital gain is because interest rates have gone down since I purchased them a few years ago thus the value has gone up.
Quote:
Originally Posted by pb4uski
I'm not sure it will sugar off as you think it will. For the purpose of thinking about this I'm assuming that interest rates stay flat for a long time.
Any unrealized gains in the underlying bond portfolio will decay as the bonds mature and be reinvested at lower interest rates, but will not impact the cash flows of the portfolio so it won't impact the funds future dividends at all.
If rates stay the same and all interest were distributed and maturities reinvested, eventually the NAV would drift to the par value per share of the underlying bond portfolio.
So let's say that the par value per share today is 100 and the fair value per share is 120 and the average coupon is 4% and market yield is 1% . Eventually, the 120 will drift down to 100. If you bought the fund today you would pay 120 and receive higher than market interest distributions based on a 4% coupon partially offset by the amortization of premium from 20 to zero.... so your total return would be the 1% market yield. As a fund holder, your amortization of premium is the decline in the NAV that you can later realize when you sell and get a tax benefit.
To be fair there are many moving part in reality, but from the 100,000 foot level....
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08-14-2020, 05:07 PM
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#4
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Jul 2014
Location: Spending the Kids Inheritance and living in Chicago
Posts: 16,972
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OP - I've had the exact same consideration for a taxable account I manage.
The gain in BND is worth a few years of interest.
currently BND earns 1.15% SEC yield, I could sell it and get the LTCG, and then invest in VSGBX yield of 1% SEC.
It would take about 10 yrs of the 0.15% interest to catch up the the LTCG value.
Should VSGBX fall in value in the next 3 years, it would be a offsetting loss of course.
I might therefore invest in 1% CD's (if I could find any).
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Fortune favors the prepared mind. ... Louis Pasteur
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08-14-2020, 10:57 PM
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#5
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Recycles dryer sheets
Join Date: Jul 2017
Location: Southern California Area
Posts: 99
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Thank you sunset. So I assume that you don't see any pitfalls I'm missing, other than of course if whatever I replace it with
drops, it will be a loss (which is a given).
Quote:
Originally Posted by Sunset
OP - I've had the exact same consideration for a taxable account I manage.
The gain in BND is worth a few years of interest.
currently BND earns 1.15% SEC yield, I could sell it and get the LTCG, and then invest in VSGBX yield of 1% SEC.
It would take about 10 yrs of the 0.15% interest to catch up the the LTCG value.
Should VSGBX fall in value in the next 3 years, it would be a offsetting loss of course.
I might therefore invest in 1% CD's (if I could find any).
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08-14-2020, 11:03 PM
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#6
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Give me a museum and I'll fill it. (Picasso) Give me a forum ...
Join Date: Jul 2014
Location: Spending the Kids Inheritance and living in Chicago
Posts: 16,972
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The only pitfall I've thought of:
Is if I buy something that falls in value as much as the original (in my example BND).
While the fall in value is a loss, it would be dumb to pay the LTCG tax on BND, and then x years later claim a same sized loss whatever replaced it.
Which is why I thought of CD's , or just pick something that has less interest rate risk.
__________________
Fortune favors the prepared mind. ... Louis Pasteur
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08-15-2020, 06:26 AM
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#7
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Thinks s/he gets paid by the post
Join Date: Jun 2013
Posts: 2,518
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I have the same situation, but with individual bonds. I get that capital gains rates would be a tax now at 15%, but I can't imagine what I'd invest the proceeds in. I always hold to maturity.
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"Luck favors the prepared mind"
Pasteur
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