trading bond funds to avoid taxes on interest distributions

Your goal is to turn potential dividend distributions into cap gains/loses? Where does the 40% tax rate come into play? Dividends would have favorable treatment, but short term cap gains, not. I'm missing the point here, sorry. Your risk in junk bonds seem far higher than any tax consequences.

Joe

The distributions paid by junk bond funds are from interest payments and are taxed as ordinary income. The 40% represents a typical federal

For the record, JNK had no qualified dividends in 2008.

The word you're looking for here is that dividends on junk bonds are not "qualified dividends" and are taxed, therefore, as ordinary income. It's qualified dividends which get the better (cap-gains) rates.

For more info, see IRS Pub 550:

Whether it makes sense to turn ordinary income into short-term cap-gains, I suppose it's possible, particularly if you have short-term cap losses being carried forward and which you want to burn off. But it's probably generally not worth the effort.

Maybe. But do you see why it would be worth the effort if these funds distributed income only annually? Is there anything stopping them from doing that? I think the problem is that lots of bond fund owners expect "income" in the form of a monthly distribution, even though they could achieve the same thing themselves by selling shares of the fund each month.

There are accounting and investment issues which make it better for them to distribute the income more frequently. For one, they have to distribute it regardless, and if it accumulates, what do they do with it in the meantime - leave it in low-interest cash? For two, it also accumulates with every trade they make, as bonds trade with their accrued interest.

I'm still not sure why you want to turn ordinary income, taxed at your highest income tax level, into short-term capital gains - also taxed at that same, highest income tax rate. Again, the main advantage I can see is for burning off some carried-forward cap-losses.

But the same 40% tax rate applys to short term capital gains as to the dividend (interest) payments, so what is the point?

It is never a good idea to let the tax tail wag the investment dog. If you don't want to pay the taxes on junk bond funds then buy high yield muni bond funds.

A lot of people have capital losses these days and can use them to offset capital gains.

Brian

If you ran a mutual fund focused on relatively illiquid investments like high-yield bonds, would you want to set up this kind of "opportunity" for investors to avoid the income distributions? It sounds like something you would want to specifically avoid, through more-frequent distributions.

Think of the cash inflow/outflow problems it could create if people capitalized on it. You'd have to liquidate a bunch of the portfolio to meet redemptions just before the distribution (which itself requires cash), then deal with the new money that came after the annual distribution was paid - buying back the securities you just sold to meet the redemptions! The round-trip double whammy of transaction costs could be a real hit to NAV, given how hard it can be to buy or sell this type of bond. The same is probably true of any of the high-yield securities. So it's a catch-22, for funds where it would be an opportunity to exploit, the managers have a reason to distribute more frequently so this isn't worth doing.

But more generally, good tax management can involve selling a mutual fund before a big distribution, for the same reason you're getting at - that's pretty standard. I just wouldn't expect it to be a regular strategy to use for a fund.

-Tad

That is true, but not a stated concern of the OP. The OP said "I wish there junk bond funds that paid distributions annually or quarterly, which would make it easier to avoid taxes on income distributions."

But it was an answer to your question as to why someone might want to take cap gains rather than dividends.

Brian

I'm pretty sure what B was thinking of was selling the fund immediately before the distribution, resulting in a capital gain (either short or long-term). Then, using capital losses on Schedule D to "cancel out" that capital gain. It's something you could consider anytime you sell a mutual fund to avoid a pending income distribution, when the sale results in a gain.

What you may be getting at is that you wouldn't be able to routinely turn it into a long-term capital gain, unless the fund shifted its distribution date a bit later each year. If you buy a fund the date after its annual distribution, and the distribution date is fixed each year (more or less), then selling the day before the next year's distribution would result in a short-term capital gain/loss.

-Tad