Investors who have worked with me know that I prefer to buy guaranteed investment certificates (GICs) instead of bonds in taxable accounts. The reasoning is fairly straightforward, but not widely understood. Most individual bonds that currently trade in the marketplace are sold at a premium to their par value. What this means is that you initially pay more than $100 to purchase a bond, but only receive $100 at maturity (resulting in a capital loss on your investment). If our tax system allowed Canadians to offset their regular income with their capital losses, this would be a non-issue. As it currently stands, this is a significant issue that can negatively impact the portfolios of many Canadians who hold premium bonds (or bond ETFs and mutual funds) in their taxable accounts.
To better illustrate this concept, consider a taxable investor who has the option of purchasing a Government of Canada (GOC) bond or a GIC, each yielding 1.50% and maturing in three years. As the annual interest of the GOC bond is higher than the yield-to-maturity (3.22% versus 1.50%), we know that this bond is trading at a premium to par. As we can see, the initial cost of the GOC bond is $105,000 and it matures at $100,000 (resulting in a capital loss of $5,000).
The after-tax absolute dollar return of the GOC bond is only $177, relative to the GIC return of $2,532. If the premium bond investor has the ability to offset capital gains with his $5,000 capital loss, his after-tax return would increase to $1,337 (still well below the after-tax GIC return of $2,532).
As a general rule of thumb, investors should avoid purchasing premium bonds, bond ETFs, or bond mutual funds in their taxable accounts. If you are unsure if the average underlying bonds of a pooled product are trading at a premium to par, just visit the company website and look to see if the Weighted Average Coupon (%) is larger than the Weighted Average Yield to Maturity (%) – if it is, you have yourself a basket of premium bonds.
Source: BlackRock Canada