The Tax Advantages of Discounted Bonds Over GICs

This year has been challenging for investors. Central banks continue to grapple with inflation by implementing tighter monetary policies. As a result, bond yields have risen, causing bond prices to drop significantly due to the well-known inverse relationship between the two.

The good news for fixed-income investors is that the upheaval has created an opportunity to purchase bonds and Guaranteed Investment Certificates (GICs) at the most attractive yield levels in many years. Taken at face value, it would appear GIC yields are more attractive, but are they the best option? 

This article will compare purchasing bonds at a discount versus GICs and the tax advantages of this approach so that you can make an informed decision about where to put your money.

Discounted Bonds vs. GICs

While GICs provide more income than a discounted Government of Canada bond, the bond provides you with a higher return from an after-tax perspective in non-registered and corporate accounts.

Investors can actually increase their after-tax yield by switching from GICs to high-quality bonds that trade at a discount.

Tax Advantages of Buying Bonds at a Discount

In a higher-yield environment, there are a number of reasons why investors should favour discounted bonds over GICs:

1. Interest paid on GICs is fully taxed at your income tax rate: GICs are interest-bearing investments, and the interest earned is fully taxable at the investor's marginal income tax rate. Depending on the individual's income level, this tax rate can be quite high, reducing the overall return on the GIC investment.

2. Bonds purchased at a discount to par have both an income component and a more favorably taxed capital gains component: When you purchase a bond at a discount to its par value, you benefit from two types of returns. First, there is the coupon interest, which is the income component. Second, there is the capital gains component, which is the difference between the discounted purchase price and the bond's par value. Capital gains are generally taxed at a lower rate than income, making this component more tax-efficient.

3. The difference between the discounted price and par is taxed at the client's capital gains tax rate: The capital gains component of a discounted bond investment is taxed at the investor's capital gains tax rate, which is usually lower than the income tax rate. This tax advantage allows the investor to keep more of the return on the bond, ultimately leading to a higher after-tax yield.

4. The coupon interest is taxed at the client's income tax rate: The income component of a bond investment, the coupon interest, is taxed at the investor's marginal income tax rate. This is the same tax treatment as the interest earned on GICs. However, because the discounted bond also has a more tax-efficient capital gains component, the overall tax burden may be lower than that of a GIC.

5. This can lead to meaningfully different after-tax yields at comparable levels: The combination of the more favorably taxed capital gains component and the income component in discounted bonds can result in a significantly different after-tax yield when compared to GICs. As the capital gains component is generally taxed at a lower rate, the investor's overall tax burden is reduced, leading to higher after-tax yields at comparable investment levels.

The Pros:

In addition to the higher after-tax yields, bonds offer other advantages over GICs, including:

• Liquidity: Bonds are generally more liquid than GICs, offering investors greater flexibility in managing their portfolios.

• Potential for capital gains before maturity: In a downward trending interest rate environment or as the bond pulls to par, investors may realize capital gains before the bond reaches maturity.

The Cons:

Of course, bonds have a downside when compared to GICs, including:

• No CDIC or CUDIC insurance: Unlike GICs, bond investments are not insured by the Canada Deposit Insurance Corporation (CDIC) or the Credit Union Deposit Insurance Corporation (CUDIC). Your investment is only secured against the issuer's credit, and this risk can be minimized by sticking to high-quality issuers.

• Price changes in the client's account: Bond prices are constantly changing, whereas GICs are reflected in the purchase price. This can be a double-edged sword, as the bond's price can go either up or down.

A Real-Life Example

Consider the Bank of Nova Scotia (BNS) bond with a 1.4% coupon and maturity date of 11/01/27. The bond is currently trading at around $87.587 with a 4.427% yield to maturity (YTM). If held to maturity, this bond will have approximately $12.5 in capital gains amortized over approximately 4.5 years, taxed at 25%. The remaining yield comes from the 1.4% coupon (paid semi-annually), taxed at 50%. The after-tax yield would be 2.972%.

To achieve the same after-tax yield using a GIC with a 50% income tax rate, you'd need an equivalent yield of 5.944%.

Comparing a BNS bond and a GIC with the same term and yield-to-maturity. For illustrative purposes only. Data as of April 30, 2023.

Bottom Line

Purchasing bonds at a discount offers a number of advantages for wealthy individuals and institutions, particularly in terms of tax efficiency and potential returns. Common sense suggests that the ideal time to purchase bonds is when inflation rates are above average, as higher yields are offered to compensate for the associated risks. This strategy is particularly effective for those with a long investment horizon, as the likelihood of lower inflation in the upcoming years is increased. However, it's essential to be aware of the risks involved and to carefully evaluate each investment opportunity. By considering the pros and cons, you can make an informed decision about whether discounted bonds should be a part of your investment strategy.

If you have any questions about how to optimize your tax strategy and amplify your returns with discounted bonds, you can call us at 604-643-0101 or email cashgroup@cgf.com.