Fixed-Income Taxation & Implications for the Active vs Passive Debate

Before diving into an analysis of active versus passive management in fixed-income, it may be helpful to cover a few foundational topics. First up is taxation.

Tax-efficiency is major tailwind for passive management in equities, but not so much in bonds.

First, let’s look at some reasons why equity index funds are tax-efficient:

  • Equity returns are composed of both appreciation and dividends. Under the current US tax code, short-term capital gains are taxed at ordinary income rates and long-term capital gains are taxed at 15-20%. Furthermore, “qualified dividends” also receive favorable tax treatment. Thus, there are a lot of tax benefits to reducing turnover in an equity portfolio.
  • The ETF structure allows for in-kind redemptions (and creations, but that’s beside the point) and many equity index fund managers have been able to minimize or avoid any capital gains exposure since their inception.

Now let’s examine how these factors contrast with fixed-income:

  • The majority of a bond’s return is from interest. Bond prices do fluctuate and investors can capture gains and experience losses, but a bond will only return a fixed-amount over its life. Hence the term fixed-income. Under the current US tax code, interest income is taxed at ordinary income rates. Even if an investor captures some appreciation, he/she will likely need to attribute a portion of the gain as income. Thus, there is not as much of a tax incentive to hold on to bonds for longer than need be, as investors will largely be taxed at ordinary income rates regardless of holding period.
  • The bond universe is much larger than the stock universe, but also less liquid. Thus, bond ETFs utilize in-kind redemptions less than their equity fund counterparts, which means that there is often capital gains exposure.

Obviously the tax laws can change, but passively-managed fixed-income does not currently enjoy the same tax benefits as passively-managed equities. This does not mean that active management is necessarily better in fixed-income (that depends on many other factors which we’ll explore in coming weeks), but the hurdle is not quite as high.