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4 Bond Funds With Tax Issues

Dropping proverbial nickels and dimes adds up.

Securities In This Article
Hartford Strategic Income A
PIMCO Emerging Mkts Lcl Ccy and Bd Instl
Columbia Convertible Securities A
Hotchkis & Wiley High Yield A

Taxes, like fund expenses, can erode investment returns. For taxable-bond funds (held in taxable accounts), investors should be aware of the aftertax returns to maximize long-term performance. Investors typically pay taxes on ordinary interest income, but other factors, such as higher portfolio turnover or strategies emphasizing income over capital preservation, can make things worse.

Morningstar’s tax-cost ratio measures the tax impact of regular interest and capital gains distributions on which investors must pay income taxes for the year they are received. This ratio, which isolates the effects of taxes from a fund’s management, measures how much of a fund’s annualized return is reduced by taxes on fund distributions. This helps investors evaluate if a manager limits taxable distributions or where to position certain funds among taxable and tax-deferred accounts to maximize tax efficiency. For example, if a fund had a 2% tax-cost ratio for the three-year time horizon, it means that, on average each year, investors in that strategy lost 2% of their assets to taxes. If the fund had a three-year annualized pretax return of 6%, an investor in the fund took home about 4% on an aftertax basis. This metric is slightly different from aftertax returns that measures the load-adjusted aftertax performance but can also be useful when evaluating the net returns to investors. Moreover, the effect of taxes can have a larger relative impact on overall returns or exacerbate losses during negative performance periods.

For bond market investors, dropping these proverbial nickels and dimes adds up. Below, we have identified four taxable fixed-income funds whose tax-cost ratios are relatively high for their asset classes.

Hotchkis & Wiley High Yield HWHAX

This high-yield bond strategy’s emphasis on smaller-cap issuers of junk-rated debt generates higher yields and higher ordinary income than its median rivals, resulting in a bigger tax liability for investors. The fund’s five-year annualized 2.1% tax-cost ratio ranks about 0.3% higher than other highly rated high-yield strategies. While this strategy’s 0.6% five-year return through October 2022 lagged 85% of peers, its aftertax 1.0% loss is one of the worst among its high-yield rivals. In addition, this strategy continues to experience outflows, which can lead to forced selling and a potentially higher tax bill.

Hartford Strategic Income HSNAX

This multisector bond strategy, which has a Morningstar Analyst Rating of Bronze, uses its flexibility to invest across global fixed-income markets in search of current interest income for investors. With more than half of its portfolio in high-yield debt, its 2.0% five-year tax-cost ratio was about 50 basis points higher than other highly rated rivals. In 2021, this fund also made both short- and long-term capital gains distributions, contributing to its tax inefficiency. Its 1.1% five-year (through October 2022) aftertax annualized loss was about 160 basis points worse than its pretax result. Its 60th percentile performance and tax inefficiency can be a double whammy for investors.

Pimco Emerging Markets Local Currency and Bond PELBX

Pimco’s flexible emerging-markets debt strategy can invest across various developing countries and their currencies. Income distributions are high in this volatile asset class, but this Neutral-rated fund’s five-year annualized 2.2% tax-cost ratio was one of the highest among Morningstar Category peers and had a relatively large aftertax impact. The tax drag exacerbated this strategy’s five-year (through October 2022) annualized pretax 1.9% loss, resulting in a 2.2% aftertax annualized loss.

Columbia Convertible Securities PACIX

This convertible-bond fund navigates the complexities of this hybrid asset class that combines the characteristics of bonds and stocks in one security. The fund pays out more capital gains than a traditional bond fund does. This Bronze-rated fund’s three-year 3.8% tax-cost ratio is a significant drag on overall performance; its median peer’s tax-cost ratio is 2.7%. Over this period through October 2022, the tax impact of its 10.0% annualized pretax result netted investors just 5.7% after taxes.

Investors can use these tools to keep more of what they earn by selecting a strategy and manager that limits the impact of taxes on performance. Bond investors will remember 2022 for rising yields, and while the higher income could be beneficial for bond investors, it also could come with a larger tax bill. Paying attention to tax efficiency can add up over the long term.

This article previously appeared in Morningstar FundInvestor.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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About the Author

Paul Olmsted

Senior Manager Research Analyst
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Paul Olmsted is a senior manager research analyst for Morningstar Research Services, LLC, a wholly owned subsidiary of Morningstar Inc. He is responsible for manager research of fixed-income mutual funds.

Before joining Morningstar in 2021, Olmsted led fixed-income manager research for Plante Moran Financial Advisors, a large Registered Investment Advisor based in Michigan. He was responsible for due diligence of traditional taxable and municipal mutual funds and separately managed accounts. In addition, he led research for illiquid credit alternative strategies and contributed to fixed-income asset-allocation recommendations. Previously, he was a taxable-bond trader and head of municipal underwriting and trading for Oppenheimer & Co. in Detroit.

Olmsted holds a bachelor's degree in finance from Western Michigan University.

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