Bond Fund Investors Could Be In For Tax Shock, Say Analysts

by Carla Johnson, Investors Offshore.com

17 June 2003

Whilst a further cut in the federal interest rate may drive up the value of bonds further in the short term, the prospect of a weakening bond market in the coming months may lead to some investors experiencing an increased tax hit.

As interest rates have been in a long-term downturn over the past few years, so bonds have appreciated, as the two generally follow an inverse correlation. However, with many analysts and commentators forecasting that we could be somewhere near the top of the market, the next significant movement in price could well be to the downside, prompting a sell-off of bonds by fund managers in the coming months.

With the average bond fund turnover calculated at 161% at present, according to Morningstar, there is a high chance of significant distributions of capital gains in the short term. Whilst this will benefit investors who have been in the market for some time, those who are just entering the market could find themselves facing a declining market, coupled with a large tax bill for capital gains.

'It's a good problem to have, because at least you have gains, but if you are going into a bond fund today and the market turns and you wind up with poor returns and a tax bill, you won't be happy,' B. Clark Stamper, president of Stamper Capital and Investments, told the Boston Globe.

It is a situation that is very similar to that of equity markets at the onset of the recent downturn, when mangers passed on stock profits to investors after a year of falling prices in the form of capital gains. However for some investors, taxes were owed on "phantom gains" during 2000 and 2001 as a result.

With the bond market possibly in the same position as the equity markets were two or three years ago, investors may be facing a similar situation. Nevertheless some analysts feel that the shock will not be nearly as severe as that felt by the stock markets. 'It's not the huge risk we saw in stock funds, but it is a real risk that will be out there if rates stay where they are or drop even further,' Morningstar analyst Scott Berry told the Globe. 'It won't be the magnitude of gains we saw in stock funds, but it will be noticeable,' he added.

Analysts forecast that longer term government bonds and municipal bonds will be the most likely areas to witness a sell-off, with most anticipating a 5% to 10% distribution.

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