Capital Losses Could Be Bonus for Some Portfolios

Mutual-fund shareholders should never let tax considerations dominate their investment decisions. That’s like letting the tail wag the dog.

But for people considering bond funds at today’s depressed prices, the capital losses with which many portfolios have been stuck could make these products a bit more attractive.

Here’s why:

Bond prices have declined across the board in the wake of sharp interest-rate hikes in 1994. Losses on individual bonds, once locked in or “realized” by the portfolio manager, can be carried forward or used to shelter future capital gains from taxation for up to five years. In addition, unrealized or paper losses have the potential to shelter gains, assuming these money-losing positions are eventually sold.

It’s worth noting that the rules are different for capital gains, which must be passed along to shareholders in the year realized. Thus despite a decade-long bull market that endured through 1993, most bond funds aren’t sitting on huge gains.

Morningstar Mutual Funds of Chicago counts about 50 bond portfolios with net capital losses equal to 40% or more of assets. If you invest $10,000 in such a fund and interest rates decline sharply in future years, boosting the fund’s price, your investment could appreciate to $14,000 before you would face any capital-gains taxes.

“This can be a real nice bonus, especially since you’re not giving up anything for it,” says John Rekenthaler, editor of Morningstar Mutual Funds.

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Unfortunately, this tax-sheltering benefit does not apply to dividends, which are normally bigger than capital gains on bond investments.

A fund’s semiannual and annual reports to shareholders will list losses, but the information can be hard to spot and will already be somewhat dated by the time investors receive the reports. Using this information, Morningstar calculates a tax analysis that includes both unrealized and realized losses, less any gains in the portfolio. The Value Line Mutual Fund Survey, a rival publication based in New York, tracks unrealized gains or losses only.

As a rule, funds that hold longer-term bonds have gotten whacked the most, as interest-rate increases have wreaked greater havoc there. Government, corporate, mortgage and foreign income funds all have been hurt. Many stock funds also are sitting on significant capital losses, but in general, bond products have been hit harder.

Besides market fluctuations, another factor that determines the amount of capital losses in a fund is the degree of shareholder redemptions; when investors pull out their money in droves, managers are forced to sell more bonds at losses.

“Heavy redemptions make capital-loss carry forwards that much bigger, especially if the fund’s size is shrinking,” says Rekenthaler.

But not all investors would want to buy a fund based on the size of its capital losses.

“It might be a way to choose among two otherwise equal funds, but it would be about the 35th factor I would look at,” says Daniel Wiener, editor of the Independent Adviser for Vanguard Investors, a Watertown, Mass., newsletter.

In fact, a capital-loss strategy might not be advisable at all. For the approach to make sense, the following circumstances should apply:

* You should anticipate that interest rates will decline within the next few years. Otherwise, the fund’s price wouldn’t rise significantly, meaning there would be little if anything in the way of capital gains to shelter.

* You should plan to hold the fund in a taxable account. Little sheltering benefit would accrue to investors using individual retirement accounts or variable annuities, which automatically defer capital gains.

* Redemptions, if any, shouldn’t be so heavy as to seriously erode the fund’s asset base. That can lead to other problems, such as a ballooning expense ratio.

* The fund should meet your investment objectives and be a decent performer. Among those funds with the largest capital losses, a large percentage are commissioned funds, which wouldn’t be of interest to no-load buyers. More troublesome, many have fundamental problems for which a future capital-loss benefit won’t compensate.

“It takes some work to find decent funds with large capital-loss exposure,” says Rekenthaler. Among the hardest-hit portfolios, he observes, “most are dogs.”

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In a tough investment climate, mutual-fund companies seem willing to work harder and spend more money to keep their names and products before investors.

The investment industry--which includes fund companies, brokerages and banks--shelled out $296 million on consumer advertising during the first nine months of 1994, reports Competitrack, a New York research firm. That’s up 8% from the same period a year earlier.

Mutual funds alone accounted for nearly 53% of ad spending, or $156 million. That represented a 5% increase.