Are ‘Tax-Advantaged’ Funds Really Worth The Effort, In A Bear Market?

[This article was shared with our Inside the Income Factory members on 12/17/2022]

Tax-Advantaged vs Non-Tax-Advantaged?

Like many other writers on Seeking Alpha, I’ve spent considerable time analyzing which types of closed-end funds and other investments are best for holding in IRAs and other tax-deferred accounts, and which are better for taxable accounts. In general, I believe most writers have concluded that funds that hold high yield bonds and loans, or other debt securities that pay interest, and are therefore taxed at higher, regular income tax rates (NOT at “qualified” rates), are best held in tax-deferred or tax-free portfolios, like regular IRAs or Roth IRAs.

Meanwhile, the conventional wisdom has been that taxable investment portfolios are better off holding so-called “tax advantaged” funds or other assets that generate income that is mostly “qualified” for tax purposes. That means it generally gets taxed at lower federal tax rates: 0%, 15% or 20%, depending on whether your total income is below $83,551, or below $517,200, or above $517,200 respectively (for joint married filers; the equivalent numbers are $44,000 and $492,000 for single filers).

If we compare these “qualified” tax rates with the actual marginal rates that apply to ordinary income (shown below), we can see why investors would prefer investments whose distributions are only taxed at an “advantaged” rate of 15% (for most investors). An investor (filing jointly) with an income between $83,551 and $517,200 would pay a tax rate between 22% and 35%, depending on their overall income, on non-qualified dividends, versus 15% on qualified ones.

With that clear a choice, the “tax advantaged’ portfolio is obviously the way to go, unless you are investing in an IRA, Roth or otherwise. That’s why our Inside the Income Factory “taxable” model portfolio (as well as many other investment writers’ taxable offerings) contains mostly equity funds that either label themselves as “tax advantaged” or have a history of focusing on stocks that pay qualified dividends. They may also include municipal bond funds whose earnings, albeit at even lower yields, are completely exempt from federal taxes (and sometimes state taxes as well, depending on the fund).

The Plot Thickens In A Bear Market

Unfortunately, the choice becomes more difficult when your funds aren’t earning money. In order to appreciate the issues involved, let us first review how typical closed-end funds actually earn their total returns and fund their distributions.

As described previously, most credit funds (loans, bonds, etc.) earn most of their total return in the form of interest payments received from their portfolio of investments. Let’s imagine “Fund A,” for example, which generates a cash flow of 10% per annum in interest payments from a portfolio of corporate debt. [Some real life examples to consider might be: Invesco Senior Income Trust (VVR), which currently pays a distribution (fully covered by net investment income) of 10.4%; or Barings Corporate Investors (MCI) which has earned over 12% per annum since 1971 and currently yields 8.24%; or Pimco Corporate & Income Opportunity (PTY), with its 12.3% annual total return for the past 20 years and 11% distribution yield.]

Equity funds, by contrast, generally earn a relatively small portion of their total return in the form of cash payments (i.e. dividends) from their investments; perhaps 2 or 3%. The rest, maybe 6 or 7% or more, would generally come from capital appreciation. So let’s imagine Fund B, an equity fund, that generates a 10% total return, but with 2% coming from its equity portfolio’s dividend yield, and another 8% coming from capital gains as its portfolio appreciates. [Some real life fund examples here might be: Liberty All-Star Equity (USA) with a 10% yield and 11% per annum total return over the past 10 years; or Liberty All-Star Growth (ASG) with an 8% yield and 11% annual growth for 10 years; or Adams Diversified Equity (ADX) with a 7% yield and a 13.5% annual return over 10 years.]

In the closed-end fund world, Fund A, as a credit fund, might pay out its entire 10% return in the form of a dividend, with investors not expecting much in the way of capital gains, if any. Fund B, as an equity fund, might pay out 6 or 7% (or more) as a dividend yield, supporting it with its dividends received of 2% and monetizing (i.e. selling off) a portion of its capital gains to support the additional 3, 4 or 5+%. In the case of our sample equity funds, USA, ASG, and ADX, the most any of their distributions were covered by cash flow (i.e. by NII) was 6%. The rest was all dependent on capital gains.

In normal times, if both funds were performing as they should, an IRA investor might be indifferent to which of the two funds to choose, since the IRA investor wouldn’t be subjected to tax on either one, regardless of whether the earnings were classified as qualified or non-qualified.

But the taxable account holder would likely prefer Fund B, the equity fund, because its dividends, coming from either corporate dividends or capital gains, would likely all or almost all be qualified distributions and subject to that lower (usually 15%) rate. Whereas if they chose Fund A with its interest income, they’d be paying non-qualified ordinary income tax rates of 20 to 30% or more.

Bear Market Blues

But the calculation changes when you hit a prolonged downturn or bear market. Suppose Fund A and Fund B both hit an economic and financial downturn where their stock prices drop substantially and their total returns turn negative. Like this past year, for example.

Fund A’s market price has dropped substantially, but it continues to collect the 10% interest on its loan portfolio, and to pay out its 10% distribution. So even though its investors have suffered a large “paper loss” on their investment, they are still collecting their income, which they can either keep (some or all of it) and live on it if they are retired; or they can reinvest it and buy more of Fund A or another fund’s stock at bargain prices, increasing their future income.

So even though Fund A has gone down in price, it continues to generate real cash income that investors can reinvest to continue growing their own income. And Fund A has done this without touching, selling or reducing its own core portfolio in any way. That means it has the same core of earning assets, still intact, at the end of the year that it had at the beginning, available to crank out the following year’s distribution. The assets may be priced lower than they were a month or year earlier, but (1) that’s a “paper loss” that only becomes a real loss if you sell, and (2) more importantly to a longterm investor, if the assets have dropped in price, they can reinvest the distribution at a bargain price and even greater yield than previously.

So by reinvesting and compounding their dividend income, Fund A’s shareholders can actually increase their portfolio’s income stream from one period to the next (“give themselves a raise”) even while the paper value of their portfolio is dropping. So the “economic value” of their assets (i.e. the income it produces) is growing even through the market downturn. (Curious about “economic value” versus “market value?” Check this out.)

Meanwhile Fund B’s market price has also dropped substantially, so it is not incurring any capital gains with which to fund its distributions, as it would in more normal times. So the only cash it has coming in is the 2% dividends that its equity investments pay. If it were a traditional open-end mutual fund, it would cut back its distributions and only pay out the 2%. But if it were like most closed-end equity funds, it would continue to pay its 6 or 7+% dividend, calling it a “managed distribution.” That’s a fancy way of saying it is essentially selling off existing assets because it doesn’t have current capital gains, but it expects to make up the difference from future gains. Sort of like borrowing from the future to smooth over the current, hopefully temporary, gaps in its earnings.

As I’ve explained elsewhere, managed distributions, if continued throughout an extended downturn, amount to a fund’s selling off assets at market lows just to pay distributions that it hasn’t earned.

From a tax standpoint, this may not be a problem, since most of the 6 or 7% “managed” dividend will consist of return of capital that won’t be taxed because it’s just a return of the investors’ own money, and the real income, the 2 or so that represents actual earnings, will likely be taxed as qualified income and get the lower tax rate.

The Real Decision: Investment Choice or Tax Choice?

In more normal market periods, an investor has a reasonable chance of achieving their goal of an “equity return” level of 9 or 10%, and merely has to decide how to do it:

• An Income Factory® or other more generic income method of achieving it, through steady reinvesting and compounding of high-yielding investments, like “Fund A”,
• Or a more traditional dividend growth stock approach, with small dividend yields but an emphasis on earnings and market growth over time making up the difference, like “Fund B.”

Either approach, if held to steadily over many years, will achieve similar results. The difference is as much emotional and psychological as it is financial. The steady, predictable compounding and income growth of a Fund A strategy allows many investors a peace of mind and ability to sleep at night that they don’t have with a dividend growth approach that involves more volatile ups and downs that can be unnerving and even scare investors into taking “defensive” actions that cost them money in the long term.

On the other hand, many investors find the Fund A “slow and steady” income approach to be too much like “watching paint dry” and prefer being more actively involved on the equity side in trying to “pick winners” and indeed to literally “seek alpha;” even though they all know that, long term, the odds of anyone actually beating the averages are slim, and the odds of everyone or even a majority of investors actually doing so are zero.

Bottom line, in normal times where we think the chances of success of a “Fund A” or “Fund B” strategy are about the same, then making a choice between the two of them based on tax considerations makes sense.

But at a time like right now, the choice becomes more complicated. If we assume there is a good chance the equity markets may stay in the doldrums for the next 6-12 months, then a Fund B tax-advantaged approach may only provide us with income of 2%, although it will be taxed at the qualified rate. Of course we will have paper losses, but assuming we don’t give up on the market and sell out (which historically has been a big mistake), those paper losses won’t have any current tax consequences.

The alternative, Fund A, even though it may also continue to show paper losses, generates a real distribution of 10%, fully covered by current cash flows (what we call “net investment income” or NII). The taxable account holder has the option of buying Fund A and collecting that before-tax distribution of 10%, knowing that they will then have to pay a non-qualified tax rate of typically 20 to 30% (or even more if their income is high enough).

That presents taxable investors with an interesting choice. Do they want to stick with “tax-advantaged” income (Fund B) that qualifies for the lower tax rate, but only make a 2 or 3% return on which they’d pay that lower tax rate?

Or would they rather take a higher-yielding Fund A approach and collect 10% or so, knowing that even though they’ll pay a higher tax rate on it, their after-tax income will still be higher than the Fund B alternative?

Looking Ahead

Obviously IRA and other deferred-tax investors don’t have to worry about the tax treatment and can choose whichever of these strategies they want to, based totally on the investment merits, as they see them. That applied to me and many other IRA investors for many years. But now we find we have to take required minimum distributions that end up moving investable cash outside the tax-protected confines of their IRAs. When that happens, taxes can all of a sudden become a bigger deal for many of us than they were back when all we had were IRAs.

I had always assumed when that happened that I’d most likely move it to traditional “tax-advantaged” investment categories, including the taxable model portfolio that I’ve developed for our Inside the Income Factory members. While I do indeed own that portfolio and other equity as well (because once the market recovers I want to own both equity and credit), I now realize that – at times like this – even non-tax-advantaged portfolios may offer certain advantages for taxable investors.

I’m not suggesting members move out of our taxable model. I am merely pointing out that the non-tax-advantaged alternative doesn’t look so unattractive during bear market periods when the equity returns that incur the lower tax rates are harder to come by. So readers might wish to consider putting new money, or even some of the distributions from their taxable holdings, into credit and other funds that are still paying higher fully-earned (by NII) yields, if one’s own tax situation is such that the after-tax return on those funds would be higher than the standard tax-advantaged choices.

Those with a more optimistic view of the markets and economy might wish to just continue their current tax-advantaged strategies, and have a greater stake in equities for when the recovery finally arrives.

There is no right or wrong answer on any of this, but I thought it was an alternative worth exploring and bringing to readers’ attention.

Happy Holidays, everyone.

Steve