The Investment Scientist

Archive for May 2022

About a month ago, I wrote about the silver lining of fallen bond prices. The message I tried to get across was that the lower prices are not a bad thing: 1) You will still get your principal back; 2) You will earn higher interest income. Today I would like to tell you about another money-making opportunity presented by fallen bond prices – tax loss harvest!

This technique is usually used for stocks, but you can use it for bonds as well.

Let’s say that at the end of last year, you had $200k invested in various bond funds. Since then, bond prices have fallen about 10%. Your bond funds will show a $20k loss on paper. Now you can sell these funds to realize the loss and use the proceeds to buy other bond funds so that you have the same exposure. 

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I am writing this article one hour before today’s market close. If there are no surprises, the S&P 500 will end the day in a bear market, meaning the index is giving us a 20% discount  from its peak. As a comparison, the Nasdaq is already giving us a 30% discount. 

As savvy investors, many of my clients and readers want to know: will the discount get deeper? And how long will the discount last? Well, like I always say, nobody can predict the future, but we surely can learn from history. That’s why I have done a study of all twelve bear markets since 1950. The table below illustrates my findings:

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If you bought a bond fund three months ago, you may have seen your fund go down about 10% in value! What the heck is going on? Aren’t bond funds supposed to be safe? In today’s newsletter, I will explain what’s going on, I will explain why you should still consider your bond funds safe, and I will even give you some hidden upsides of bond funds going down in value.

What’s Going On?
Last month we saw interest rates rallying. Bonds are essentially fixed future promised payments.  The current value of a bond is the sum of all fixed payments discounted by interest rates. When interest rates go up, it stands to reason that, applying the mathematical formula, the current value of the bond will  go down. This mathematical logic applies to all bond funds. 

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From the peak, Nasdaq is down about 24% and the S&P 500 is down about 14%. I am sure when you read your investment statement, you will feel queasy and wonder if you should stay invested. I think this is a good time to review my wardrobe theory of investment. Here is what I wrote in December 2018:

Treat your investment portfolio the same way you would treat your wardrobe…

For simplicity’s sake, let’s say you acquire your entire wardrobe from Neiman Marcus. If Neiman Marcus had an across-the-board 50%-off sale, would you throw up your hands in despair and say, “Darn it, my entire wardrobe just lost half of its value. I better sell it all at the flea market or I will lose everything?”

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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