Even if the composition of a fund doesn't change, the distributions may change as the fund acquires new assets.
For example, suppose that a fund buys a 10-year Treasury bond at par for $1000 with a 4% yield. This bond will pay $40 in coupons every year. Its price may fluctuate, but the $40 coupon payment is constant, and will be distributed as a dividend (of $3.33 per month).
Now suppose that bond prices rise (and yields fall) after five years, and investors add money to the fund, forcing it to buy new bonds. The fund buys more of the same bond, but the price of the bond (now a 5-year bond) is now $1100. The bond does pay $40 in coupons every year, but IRS rules allow the fund to amortize the premium, so that $20 of the coupons decrease the basis rather than being taxed as a dividend (and then the bond will not have a capital loss at maturity). Thus this bond will pay $20 per year in taxable dividends.
(Technical note: amortization of the premium is not linear, so the $100 of taxable dividends over five years will not be quite $20 each year.)
Note that this is a cash flow difference between bonds and bond funds. If you bought the bond for $1100 yourself, you would receive the $40 annual coupon in cash. You would still pay tax on only $20 of it each year, so the tax situation would be the same as for the fund holding the bond.
For example, suppose that a fund buys a 10-year Treasury bond at par for $1000 with a 4% yield. This bond will pay $40 in coupons every year. Its price may fluctuate, but the $40 coupon payment is constant, and will be distributed as a dividend (of $3.33 per month).
Now suppose that bond prices rise (and yields fall) after five years, and investors add money to the fund, forcing it to buy new bonds. The fund buys more of the same bond, but the price of the bond (now a 5-year bond) is now $1100. The bond does pay $40 in coupons every year, but IRS rules allow the fund to amortize the premium, so that $20 of the coupons decrease the basis rather than being taxed as a dividend (and then the bond will not have a capital loss at maturity). Thus this bond will pay $20 per year in taxable dividends.
(Technical note: amortization of the premium is not linear, so the $100 of taxable dividends over five years will not be quite $20 each year.)
Note that this is a cash flow difference between bonds and bond funds. If you bought the bond for $1100 yourself, you would receive the $40 annual coupon in cash. You would still pay tax on only $20 of it each year, so the tax situation would be the same as for the fund holding the bond.
Statistics: Posted by grabiner — Sun Aug 18, 2024 8:53 pm — Replies 21 — Views 1349