If you are in the highest tax bracket and own GICs or other high-coupon-fixed-income investments in taxable accounts, you are likely paying too much tax. This article walks through the logic of why this is the case.

We are in an interesting time for fixed income investing. After a long period where interest rates were very low, interest rates rose quickly to a high level. Why is this interesting? During the period of low-interest rates governments and corporations issued large amounts of bonds at exceptionally low coupon rates. There are many bonds available with coupons of around 1% or less.

Why is this significant? It comes down to the tax arbitrage between tax rates that apply to regular interest and the lower capital gains tax rate. In Canada, we have the concept of the Capital Gains Inclusion Rate. Only half of a capital gain on an investment is included in the tax calculation. When interest rates were low, this difference in tax rates was less relevant for fixed income investing. Now that interest rates are higher, the after-tax yield becomes more important when comparing fixed income investments.

Let us briefly review how bonds are priced. In a bond, you have a maturity date, a coupon rate, a yield to maturity, and a price. The coupon and maturity dates are fixed when the bond is issued, while the yield to maturity and price move up and down inversely during the life of the bond. As interest rates for similar bonds move up the price of that specific bond moves down. The interest rates and prices for bonds move in this manner every day, but over the life of the bond the price will slowly converge to the final maturity price of $100.

The return on a bond investment is the combination of the interest received from its coupons and the capital gain from the price paid for the bond relative to the eventual maturity price. In Canada, these two sources of return are taxed at different rates, and it matters how much comes from each source when determining the after-tax return. In the current environment this difference is quite dramatic, so if you are only considering the before-tax rates when selecting your fixed income investments this may be an oversight.

So, let’s review more closely how a bond is taxed for individuals.

Taxation of bonds is divided into two components. The coupon, which is typically paid semi-annually, is taxed in the year it is paid at the regular income tax rate. The highest tax bracket for individuals in Ontario is 53.5%. If you are in the highest tax bracket and you receive a coupon of 5%, your interest earned after tax will only be 2.325%. The second component is the capital gain. This is the difference between the price paid for the bond and the price at which it matures or is sold. For the sake of simplicity, we will only consider maturing bonds. Assume a bond is purchased at $90 and held until maturity at $100, the capital gain would be $10. Given the capital gains inclusion rate of 50% the after-tax return from the capital gain would $7.325.

Calculation: $10 – $10 * (53.5% * 50%) or $10 - $2.675 tax = $7.325

Approximately three-quarters of the capital gain is retained by the investor, whereas only half of the interest is retained. One further detail is that the capital gains tax is only due when the bond is sold or matures, so there is also a tax deferral advantage. In short, individual investors in the highest tax bracket are usually much better off to invest in bonds where most of the yield to maturity is earned in the form of capital gains.

So, what is the difference in the markets today? There are a few calculations in the table below of actual bonds currently available in our discount bond ladder. This table compares the After-Tax Yield of the discount bonds to All Interest Equivalent Yield Before Tax. This is the amount of yield you would be required to earn from an all-interest security like a GIC to earn the same Yield After Tax that is earned on the bonds listed below.
 

The average yield before-tax of the bond portfolio is 4.64%, with a yield after-tax of 3.23%, but a GIC paying 6.96% would be required for the same after-tax position.

Some points of consideration. This is not relevant analysis for registered accounts like RRSPs, RIFs and TFSAs, or other non-taxable entities like foundations or not-for-profit corporations. Further, individuals in lower brackets would have some advantage, but it would need to be calculated with the specific tax rate for accurate comparison. Corporations also qualify for the 50% capital gains inclusion rate, but the calculations are more complex because the savings would pass through the Capital Dividend Account, which goes beyond the scope of this article.

In summary, if you are a high-income individual with taxable investments, a review of your fixed income investment strategy in the context of taxation is now worthwhile.