Credit Markets Favor Alpha Over Beta
PGIM Fixed Income discusses reasons for its near-term caution but long-term optimism and where to find opportunities for different economic scenarios.
Over the past decade, investors have enjoyed low interest rates, low inflation, and rising bond and equity markets, leading to an accumulation of assets that have appreciated significantly. For instance, housing prices have more than doubled in the last decade while the S&P 500 Index is up over 500% and Bitcoin is up over 1,500%. Typically, investors seeking to outright sell largely appreciated assets like these would incur large tax bills. Enter tax loss harvesting—an approach that allows investors to take losses on depreciating assets to offset capital gains elsewhere, while reducing the value of their total taxable assets and overall tax burden. As the Fed began to normalize monetary policy by raising interest rates and reducing its balance sheet to curtail inflation, a broad range of assets declined and market volatility spiked, providing a compelling opportunity for investors to harvest tax losses on their depreciated assets to offset gains from selling highly appreciated assets.
The first half of 2022 marked one of the few instances where stock and bond markets both fell. Equity investors have faced significant volatility in 2022, contrasting the low volatility seen in 2021. But the roller-coaster ride is far from over. The Fed is likely to continue tightening monetary policy until there are clear signs that inflation will decline, which in turn will keep market volatility elevated. We think we’re entering a structurally higher volatility regime as investors readjust to normal market conditions with reduced liquidity and less-accommodative policy, and that this trend will continue. Investors can turn the market volatility into an opportunity to capture tax loss benefits to offset other capital gains. Tax loss harvesters need volatility and dispersion of returns to capture tax-benefit opportunities, and 2022 has provided both in spades.
It’s hard to have a drawdown in the S&P 500 without a drawdown in the big sectors that comprise the index. The biggest components are largely growth sectors that were hurt by the rotation to value stocks given rising interest-rate expectations. Unsurprisingly, we’ve seen the largest tax-loss harvesting opportunities in the information technology, consumer discretionary, and communication services sectors, which collectively account for ~50% of the S&P 500. These sectors were each down 20% or more year-to-date through the end of May, providing ample opportunities to harvest tax losses. However, opportunities were not limited to these sectors, as all Global Industry Classification Standard sectors, with the exception of energy and utilities, are trading at lower levels than where they began on January 1.
S&P 500 Index is an unmanaged index of 500 common stocks of large U.S. companies, weighted by market capitalization. Indices are unmanaged and are provided for informational purposes only. Investors cannot directly invest in an index.
Risks—Investing involves risks. Some investments are riskier than others. The investment return and principal value will fluctuate, and shares, when sold, may be worth more or less than the original cost. Fixed income investments are subject to interest rate risk, and their value will decline as interest rates rise. Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes, and political and economic uncertainties. Investing in emerging markets is very risky due to the additional political, economic, and currency risks associated with these underdeveloped geographic areas. Investments in growth stocks may be especially volatile. Value investing involves the risk that undervalued securities may not appreciate as anticipated. It may take a substantial period of time to realize a gain on an investment in a small or midsized company, if any gain is realized at all. Real estate investment trusts (REITs) may not be suitable for all investors. There is no guarantee a REIT will pay distributions given the inherent risks associated with the market. A REIT may fail to qualify as a REIT as defined in the Tax Code, which could affect operations and negatively impact the ability to make distributions. There is no guarantee a REIT’s investment objectives will be achieved. Diversification and asset allocation do not guarantee profit or protect against loss. Investments in in Master Limited Partnerships (MLP) and MLP-related investments are subject to complicated and in some cases unsettled accounting, tax, and valuation issues, as well as risks related to limited control and limited rights to vote, potential conflicts of interest, cash flow, dilution, and limited liquidity and risks related to the general partner’s right to force sales at undesirable times or prices. MLPs are also subject to risks relating to their complex tax structure, including losing its tax status as a partnership, resulting in a reduction in the value of the MLP investment. Many MLP investments are in the energy sector and subject to a greater degree to risk of loss as a result of adverse economic, business, regulatory, environmental, or other developments affecting industries within that sector than investments more diversified across different industries. Diversification and asset allocation do not guarantee profit or protect against loss.
The views expressed herein are those of investment professionals at PGIM Custom Harvest at the time the comments were made and may not be reflective of their current opinions and are subject to change without notice. This commentary is not intended as an offer or solicitation with respect to the purchase or sale of any security or other financial instrument or any investment management services. This commentary does not constitute investment advice and should not be used as the basis for any investment decision. This commentary does not purport to provide any legal, tax, or accounting advice. PGIM Investments LLC is a registered investment advisor with the U.S. Securities and Exchange Commission. PGIM Custom Harvest does not provide tax, legal, or accounting advice. This material is for information purposes only, and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your own tax, legal, and accounting advisors before engaging in any transaction.
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