Given the volatility in fixed income I thought it timely to highlight discount bonds as one area in the capital markets where we see value. This is not a recommendation to purchase or sell securities but instead a summary of our current line of thinking.

Interest rates (& by extension fixed income markets) have changed dramatically over the past few years. In 2020, rates declined to new all-time lows in many markets and, in Canada, the 10-year government yield dipped below 0.5%. At the time of writing, the yield on the Canada 10-year is about 3.40%, a level not seen over a decade.

Government of Canada 10-year yield

Source: FactSet

While existing bondholders have suffered meaningfully over the past 2 years, the speed and magnitude of the rise in rates has created interesting opportunities for those looking to enter the fixed income segment. This is especially true for taxable investors. Bonds that were issued by governments and corporations in 2020 when rates were very low are now trading at sizable discounts to par (below $100) and offer compelling after-tax returns. This is because most of the return from these bonds will come in the form of tax-friendlier capital gains rather than interest income. I have included a representative sample of Canadian dollar discount bonds below to highlight this feature. They all trade well below their issue price of $100 and will benefit from a “pull to par” mechanism (mature at $100). The taxable equivalent yield represents the pre-tax yield that would need to be paid on a GIC or bond trading at par in order to provide the same after-tax yield of the given security. Yields are annualized.

All bonds, including those listed above, are subjected to movements in interest rates. When interest rates move higher, bond prices move lower (and vice versa). Generally speaking and assuming all else is equal (issuer, credit risk, etc.), the longer the bond the greater its sensitivity to interest rate fluctuations. Higher volatility is one of the reasons why longer bonds generally offer a premium yield. Despite their relatively short terms to maturity, the bonds listed above offer reasonable compensation for investors, particularly for those holding them in a taxable account (non-registered).

Feel free to reach out if you have any questions.