Asset Location and Flexibility: Keys to Fixed Income Success

Finding balance between rate movement and uncertainty

By Doug Wolff

Financial advisors know that retirement goals, investable assets and tax circumstances are unique to each client. One thing that remains consistent, however, is a client’s need for diversified exposure across asset classes.

The Federal Reserve has made it clear that interest rates will eventually rise, but comments made by the board in January signaled a wait-and-see approach. This puts advisors in a precarious position. Rising rates will have an impact on clients’ fixed income holdings, but the unpredictable timing of those rate hikes—perhaps as early as mid-2015—creates investment uncertainty.

Fixed Income in a Rising Rate Environment

Simply put, advisors can’t exit all fixed income positions, even in the face of rising interest rates. While the exact allocation is often debated, it’s generally accepted that clients need to have some exposure to fixed income in their portfolios.

Fixed income is a key part of a diversified portfolio and these holdings often play an important role in drawdown strategies, generating income and reducing portfolio risk. Looking forward, though, fixed income holdings are facing a challenging and uncertain future with the eventual end of a 30-year bull run in bonds. Rising rates will undoubtedly be a driving force behind many of the asset allocation decisions made in 2015 and beyond. Moving forward, this means asset location will take on an even more important role in fixed income investing.

Advisors who position assets, especially tax-inefficient bonds, with an eye toward minimizing tax burdens will give their clients a greater chance of creating optimal retirement outcomes, even in a rising rate environment.

Tax Inefficiency of Fixed Income

When it comes to tax efficiency of investments, asset class and investment style generally trump all else. A quick review of where fixed income investments fall on the list of inefficient investments provides some context as to why asset placement will play a significant role in a rising rate environment.

Taylor Larimore, a retired chief of the Federal Small Business Administration's finance division and a former IRS officer, ranks asset classes by tax efficiency, from least efficient to most efficient:

• High-yield bonds
• Taxable bonds
• REITs
• Small-cap stocks
• Large-cap stocks
• International stocks
• EE and I-bonds
• Tax-exempt bonds

Morningstar’s mutual fund tax-cost ratios give a general sense of the relative tax efficiency of these asset classes. These tax-cost ratios measure how much a fund's annualized return is reduced by the taxes investors pay on distributions, including ordinary income tax, short-term capital gain tax and long-term capital gain tax.

Morningstar assumes ordinary income tax liabilities based on the top federal income tax bracket and top long-term capital gain tax rate for each year (e.g., 39.6 percent income tax rate and 20 percent long-term capital gain tax rate in 2014).

Source: Morningstar Premium, 2/17/2015

Why Location Matters

While clients’ individual circumstances will drive the specific allocation of fixed income assets, it’s clear the tax inefficiency of fixed income investments can create a significant drag on clients’ portfolios.

Simply reviewing the Morningstar tax-cost ratio table shows that any taxable bonds held within a taxable account will see a significant haircut on returns, regardless of the specific strategy implemented by advisors. Take, for example, long-term bond funds. The category has been a top performer in the taxable bond space in recent years, and it may hold appeal for advisors looking to maintain core holdings ahead of the possible mid-year rate increase.

According to Morningstar, the average long-term bond fund returned 5.14 percent before taxes in the three years ending Feb. 17, 2015*. However, the average three-year tax-cost ratio cuts the return to 3.04 percent, reducing gains by more than one-third. Others may be looking toward high-yield bonds as part of an allocation strategy for rising rates.

While potentially more volatile than other fixed income holdings, they offer the possibility of greater yields and lower sensitivity to interest rate risk as well as some insulation against rising rates. The average high-yield bond fund returned 6.56 percent before taxes in the three years ended Feb. 17, 2015*. Yet, the average three-year tax-cost ratio reduced those returns by more than one-third to 4.07 percent after taxes.

From an efficiency perspective, taxable accounts have proven, time and again, to be poor homes for fixed income holdings. Advisors who have the foresight to place fixed income holdings into tax-favored accounts give clients a better chance at a larger retirement nest egg and the ability to maintain their desired standard of living throughout retirement.

Getting Ahead of Rates

Asset location will matter even more now that rising rates are looming. Advisors who effectively position assets ahead of the rate increase will give themselves maximum flexibility to implement their preferred strategy once rates begin to go up.

Moving fixed income assets into a modern, investment-oriented variable annuity—commonly referred to as IOVAs—while rates remain low may be a good solution for many advisors’ clients. With an IOVA, advisors have the ability to move fixed income assets into higher quality short- and intermediate-term bonds, as needed, without any tax implications. Additionally, many of these variable annuities have eliminated trading costs.

Using this strategy, advisors are free to allocate and reallocate around rising rates without triggering taxable events or incurring fees. As the name implies, investment-oriented variable annuities typically come with a wide variety of investment options, with some offering hundreds of subaccounts.

This flexibility means advisors have the ability to increase or decrease clients’ fixed income allocations within the annuity itself and realize even greater tax savings as the income generated by fixed income holdings, as well as capital gains from any holdings in the equity, balanced or alternative sleeves, will grow tax-deferred within the variable annuity.

A Case for Variable Annuities

Higher interest rates are coming whether advisors are ready or not. While it’s impossible to predict the level or exact timing of a rate increase, advisors can take steps now to help position their clients for success. Allocating fixed income holdings to a variable annuity ahead of rising rates may provide advisors with a solution. The move may help reduce clients’ tax liability—boosting the value of tax-inefficient fixed income classes—and increase advisors’ flexibility in an unpredictable rate environment.

** Morningstar Premium Fund Screener data through 2/17/2015

Annuities are long term investments suitable for retirement investing. Diversification does not assure a profit. Investing in a variable annuity through a tax qualified contract such as an IRA offers no addition tax benefit. Neither SBL nor FSBL offer accounting, investment or tax advice and nothing contained in the preceding should be construed as such advice. [Annuities offered by SBL & FSBL disclosure; SDI disclosure; affiliations disclosure] 99-00476-42 |

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