Andrew Sheets: Will the Bond Market Suffer from Tax-Loss Selling?

Investors whose corporate bond holdings have lost value in 2023 could sell before the end of the year, locking in their losses to offset gains elsewhere. Here are three reasons that they probably won’t.

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Welcome to Thoughts on the Market. I'm Andrew Sheets, Global Head of Corporate Credit Research for Morgan Stanley. Along with my colleagues, bringing you a variety of perspectives, I'll be talking about trends across the global investment landscape and how we put those ideas together. It's Friday, November 10th at 2 p.m. in London.

One of the questions that's come up on my recent travels is the risk from so-called tax loss selling. Bonds of many stripes have had a tough year, and the concern would be that investors would like to sell now and crystallize any losses to offset other gains.

Tax loss selling has been a recent driver of single stock performance, as often happens around this time of year, as noted by my colleague Michael Wilson, Morgan Stanley CIO and Chief U.S. Equity Strategist. But for corporate bonds, we think these risks look pretty modest. There are a few reasons why.

First, while corporate bonds have had a tough year, the losses aren't particularly large and indeed have gotten a lot better in recent weeks, as yields have started to rally. US investment grade bonds or the U.S. aggregate bond index is plus or minus a couple of percentage points, and we're just not sure these are big enough losses for investors to take action. In equity markets, you generally need much larger drawdowns to generate year end tax selling.

Second, the investor bases are different. Equity markets tend to see much more participation in individual stocks, which creates opportunities for tax loss harvesting. Investment credit, especially among individual investors, is more commonly done through funds, where the smaller drawdowns I just mentioned would mean less incentive to take action. These different investor bases also have different motivations. We think many individual investors, whether through funds or individual securities, invest in corporate bonds for a stable long term income. We think they're simply less likely to have the sort of trading mindset of the average investor holding stocks.

Meanwhile, institutions who hold corporate bonds also face constraints. While some may sell for a capital gains offset, others face a penalty for realizing such a loss and thus are more incentivized to hold these securities they believe remain ultimately creditworthy. And for long dated corporate bonds, which have the largest year to date losses, well, those are certainly enjoying some of the strongest end-buyer demand.

Finally, we think any tax related selling we do see in the credit market could wash at the overall market level. Similar to equities, investors selling losers at year end don't necessarily drive down the market overall, as these funds are often recycled into other securities. And indeed, October through December, when tax loss selling usually occurs, are seasonally strong months for the equity market or the credit market. And we think a similar thing could happen in corporate bonds, where investors who do sell a corporate bond fund for a tax loss may be likely to recycle this into another part of the bond market.

Total returns for corporate bonds have been tough year-to-date, but we're skeptical that these would lead to tax loss selling and another like lower. The modest scale of year-to-date losses, the nature of the investor base and the potential for any such sales to be recycled into other parts of the market are all reasons why.

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