Turning Bond Fund Income into a Long-Term Capital Gain
While bonds and bond funds are recovering a bit this year, 2022 resulted in large losses, whether you held individual bonds to maturity or owned a bond fund.
But, if you own bond funds in a taxable account, it is possible to turn some of the SEC yield into long-term capital gains taxed at lower rates, which could save a bundle. Here’s how.
Let’s look at the Vanguard Total Bond (VBTLX). As of December 12, 2023, it had an SEC yield of 4.61% but the distribution yield was only 3.49% as of December 1, 2023. Though off by 11 days, those dates are close. The SEC yield is roughly 1.11 percentage points higher than the distribution yield. The SEC yield of a bond assumes the investor holds the bond to maturity. In other words, the bond fund now holds bonds that are trading at a discount but, without defaults, will mature at par. Thus, some of the gain is from coupons and some from accretion of the principal.
Indeed, as of November 30, 2023, Vanguard shows the fund has an unrealized loss of 12.07% of the fund’s NAV. My hypothesis was that, all things being equal, the bond fund’s NAV would likely increase closer to the $100 par as the underlying bonds moved closer to maturity. I ran that by a Vanguard spokesperson who confirmed and replied:
As you pointed out, for bonds issued prior to the huge upswing in rates, the coupon is lower than the prevailing market rate, so they’re generally trading at a discount. For lower coupon bonds, less of the return will come from the coupon payment and more will come from capital appreciation going forward.