High Quality Discounted Bonds are Timely for a Number of Reasons: There are a number of instances where clients can actually increase their after-tax yield by switching from GIC's into high quality rated bonds that trade at a discount. We feel this is an opportune time for the following reasons:
- Greater yield on an after-tax basis: Because many high quality bonds trade well-below par, much of the return stream on these bonds comes in the form of capital gains rather than interest income.
- Greater capital gains than pure income is good for corporations: With the new government of Canada rules with passive income in a corporation, the guaranteed capital gains portion of the total yield does not count as "income" in the new tax rules.
- Upgrade quality: Narrow credit spreads add to the appeal of a federal bond as the yield give-up to hold a higher rated bond is minimal. In many cases, this results in a higher after-tax yield than many lower-rated bonds and GICs that carry materially higher pre-tax yields.
- A buffer against equity declines: Traditionally a benefit to holding bonds was they tend to rise in value as the value of equities drop. However, in an attempt to squeak out marginally better yields, investors have gravitated towards GICs. GICs do not have the same stabilizing effect on your equities as bonds do because they do not fluctuate in price once you've purchased them.
- A significant after-tax bump on cash: Unless the Bank of Canada and/or the Federal Reserve increase rates significantly quicker than expected, shorter-term discounted bonds provide an opportunity for investors to increase their yield on cash with a higher probability of outperforming through the life of the bonds.
Discounted Bonds Provide a Higher After-Tax Yield than GICs: Buying bonds trading at a discount (below $100) provided clients with non-registered or corporate accounts with a more tax efficient fixed income return stream because some of the return comes as a capital gain rather than interest income. In addition to the favourable tax treatment, we believe it is particularly timely to be adding high quality discounted bonds to a portfolio because narrow credit spreads mean investors are foregoing a minimal amount of incremental yield to improve quality.
Discounted Bonds Provide an Opportunity to Upgrade Quality and Pick-Up After-Tax Yield: Given the availability of tax-efficient high quality bonds at a time of narrow credit spreads, investors have a unique opportunity to both upgrade quality and increase after-tax yield.
A Higher Yielding Alternative to High Interest Savings Accounts: The same after-tax yield math can be extended to a comparison of some of the shorter-term discounted bonds we are recommending as a higher yielding alternative to holding cash in a high interest savings accounts (HISA). On a static basis (assuming no interest rate increases), the shorter-term bonds offer a material yield advantage compared to the HISA and this is even more pronounced on an after-tax basis because the higher return comes in a more tax-efficient form. The caveat here is that the HISA rates could increase as central banks increase interest rates over the full term to maturity of a shorter-term bond, but a material increase would be required to generate a higher average yield than one of these bonds over the life of the issue.
The Relative Yield Advantage of Short-Term Bonds versus HISA is Even More Pronounced in USD: Buying a high quality short-term bond offers an even larger yield bump for an investor holding USD cash as the USD HISA rate is actually below the Fed Funds rate and the US bond yields are higher than Canadian bond yields. The relative value is so compelling in the US market that an average investor can more than triple their after-tax yield from HISA.