The COVID-19 pandemic has depressed global yields, which has created a challenging environment for income investors. While government and corporate bonds have exceptionally low yields, the emerging decentralized finance, or DeFi movement in crypto markets has created a new opportunity to generate attractive yields.
Let’s take a look at the global lack of yield and opportunities in the crypto market to generate yield through lending and other strategies.Decentralized Finance has created an opportunity for crypto investors to generate yield, but there are some important caveats to keep in mind. Click To Tweet
The Global Lack of Yield
The COVID-19 pandemic has led to record-low yields as central banks cut interest rates to stimulate the economy. For example, 10-year Treasury yields stand at just 0.82% while German 10-year bond yields are a negative 0.56%. The Federal Reserve has set official interest rates at just 0.25% and committed to buying bonds in the open market to inject liquidity.
United States 10-Year Treasury Bond Yields – Source: FRED
Corporate bonds yields haven’t fared much better with the iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) yielding just over two percent. While high-yield junk bonds offer greater yield, low-quality companies have deteriorating financial conditions caused by the COVID-19 pandemic that makes them relatively high risk for income investors.
While governments have dramatically increased borrowing, economic growth expectations remain muted and few analysts expect near-term inflation. Central bank purchases of government and corporate bonds have also kept a lid on bond yields—and these programs are expected to remain in place for some time to combat the economic decline.
Crypto Assets & Yield Generation
The rise of Decentralized Finance, or DeFi, has created an opportunity to generate yield on crypto assets. For example, DeFi lending automatically negotiates loans directly between strangers anywhere in the world without a middleman. DeFi hopes to eventually replace conventional financial services with more efficient crypto-powered alternatives.
Note: Generating income from DeFi differs from so-called high-yield investment programs (HYIP) and other schemes designed to generate income through proprietary trading of cryptocurrencies.
Compound’s Market Overview – Source: Compound
Some of the most popular DeFi platforms include:
- Compound: A blockchain-based borrowing and lending dapp that enables crypto holders to earn interest on their assets. Interest rates are dynamically calculated based on real-time supply and demand.
- Uniswap: A crypto exchange that runs entirely on smart contracts. With the platform, investors can become a liquidity provider by supplying crypto to contracts and earn a share of the exchange fees.
There are many reasons that borrowers may want to take advantage of these platforms. Most importantly, borrowing crypto assets means that traders can keep their existing trades intact, which could result in a lower tax liability (e.g. short vs. long-term capital gains). As long as collateral is not sold or exchanged, then there are not taxes triggered on a loan itself.
Of course, DeFi involves risk factors that investors should consider before committing their assets. Any lending activity involves the risk of default by a borrower that fails to repay their loan, while all crypto assets have greater volatility than conventional fixed income assets. You could also be hit with unexpected tax liability via token distributions.
The tax treatment of decentralized finance income depends on type of activity and the underlying platform. Since capital gains tax rates can be significantly lower than ordinary income tax rates, investors should carefully consider the tax implications of a DeFi platform before committing capital to any given opportunity.
Capital Gains Tax Rates in 2021 – Source: Forbes
Let’s take a look at two possibilities for DeFi lending:
- Ordinary Income: DeFi lending platforms that pay earnings from interest directly to crypto balances (e.g. earning ETH from lending ETH) are typically subject to ordinary income tax since it’s similar to any other interest-bearing investment.
- Capital Gains: DeFi lending platforms that issue their own tokens, known as Liquidity Pool Tokens, enable investors to recognize the income as a capital gain since cryptocurrencies are treated as property under IRS law.
Many DeFi platforms offer governance and incentive tokens in exchange for activity on their platform. While these tokens are a critical component in yield calculations, they are often taxed as ordinary income based on their current market value. Selling these tokens may also trigger a capital gain or loss on the change in value since they were acquired.
Investors should also consider how to use other parts of their portfolio to reduce tax liabilities. For example, tax loss harvesting is a great way to realize losses from crypto trades and investments in the current tax period, which can be used to offset income from DeFi or even other types of securities in your portfolio.
Traders and investors should be mindful of these tax implications when building crypto income into their portfolios. By being mindful of tax rates, you can minimize the amount of taxes that you pay and increase your after-tax income. Crypto tax tools, like ZenLedger, can help you better understand the tax implications of your portfolio and minimize tax exposure over time.
The Bottom Line
Global yields have reached new lows amid the COVID-19 pandemic, but emerging decentralized finance applications could provide an opportunity to yield-starved traders and investors. By lending crypto assets or providing liquidity, you can generate attractive yields on your crypto portfolio without the risk of high-yield junk bonds or other conventional investments.
If you trade crypto assets, ZenLedger can help you aggregate transactions across exchanges and determine capital gains or losses. You can even identify opportunities to harvest losses to reduce your income tax liability at any point during the year.