How rising rates are turning discount bonds into after-tax bargains
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Pretend you’re an investor trying to choose between two very similar-looking bonds. Bond A is A-rated, matures in two years and has a very attractive coupon. Of course, other investors find that coupon attractive, too, so the price is high – well above the par value (the amount of money the issuer will pay at maturity). Your alternative, Bond B, also matures in two years and is A-rated. Its coupon, however, is several percentage points lower than Bond A’s. Because other investors generally don’t like making less money, Bond B’s market price is much lower than par. Which do you choose?
Now, because you know a little something about fixed income, you’re going to fight the rookie urge to jump at Bond A just because it has a higher coupon, or at Bond B just because it’s cheaper. Instead, you’ll look at the two bonds’ yield-to-maturity, which factors in the impact of buying at prices lower or higher than par, and see that – voila! – both should deliver about the same return. So your educated answer to the question of which bond to buy might be: It doesn’t really matter.
Good for you! Too bad that – depending on what kind of investor you are – you might very well be wrong. And that’s because you have forgotten one factor that pretty much everybody else would rather forget about, too: taxes.
As Jeff Carter, Portfolio Manager and Chief Compliance Officer at Canadian institutional investment management firm Canso Investment Counsel Ltd., points out, tax on capital gains and tax on interest are calculated at different rates. Generally, capital gains are taxed at half the ordinary income tax rate; on interest, you have to pay full freight. So while Bond A will pay a hefty coupon when it matures, you’ll end up with a bigger tax hit than if you had bought Bond B, whose yield comes largely in the form of capital gains. As a result, Bond B’s after-tax yield may be higher – and perhaps much higher – than Bond A’s. “You have to remember that much of bond market is driven by large institutional investors, and unlike ordinary humans many of them are tax-exempt,” says Carter. “They can roll over into higher-coupon bonds without worrying about tax implications, but for taxable investors, those implications can make a big difference.”
The thing is, there are plenty of “Bond B’s” out there today, according to Carter, because rates have risen so dramatically and quickly from basically zero only a short time ago. At the start of the COVID-19 pandemic, monetary policymakers across developed countries slashed rates, and “several government bond issues had coupons of a quarter of percent,” notes Carter. “In the U.S., some coupons were set to an eighth, or half a quarter, of a percent.” This year, central banks have been hiking rates to combat rampant inflation, and bond yields have risen accordingly. (For example, the five-year U.S. Treasury yield sat at 3.15 per cent on Aug. 25, up about 180 basis points from the start of the year – and that’s after an early-summer rally.) The result is that low-coupon bonds issued during the COVID crisis are trading at a substantial discount. “The higher rate environment is being priced into the market,” Carter says, “and there are significantly different prices among even very short-maturing bonds with different coupons.”
How big an impact could these anomalies have on a taxable portfolio? By way of illustration, Carter cites an example from earlier this year, when a 30-year Canadian government bond maturing in 2023, with a coupon of 8 per cent, was priced at $105.64 (par=$100), for a pre-tax yield in one year of about 2.2 per cent. At the same time, a two-year government bond issued in early 2021, with a coupon of only 0.25 per cent, was priced at $97.92 – a seven-percentage-point-plus discount to the 30-year bond – for a pre-tax yield of about 2.3 per cent. That might not look like much of a difference, but factor in taxes and it becomes stark. Assuming a 40 per cent tax rate on ordinary income, the after-tax yield on the 30-year bond would be close to negative 1 per cent. “You think you’re buying a government bond and the yield is safe, but in fact it’s negative after tax,” Carter says. In contrast, the after-tax yield on the two-year bond would be roughly 1.9 per cent, thanks to the magic of capital gains taxation.
These potential opportunities go beyond government issues, Carter says: “Take it a step further and look at credit, and you see other peculiar things in the market.” One of those peculiarities noted by Carter, again from earlier this year, was a pandemic-era AA-rated bond from Nav Canada, the not-for-profit company that owns and operates Canada’s civil aviation system, maturing in 2024 with a coupon of 0.55 per cent and a market price of $95. At the same time, a comparable Bell Canada corporate bond, BBB+-rated with a five-month shorter maturity and a coupon of 4.7 per cent, was priced at $101. True, the pre-tax yield on the Bell Canada bond was higher than on the Nav Canada bond, but according to Carter the after-tax yield on Nav Canada would end up more than 100 basis points higher – even though notionally Nav Canada is a lower-risk investment. “The lesson here is to know what you’re buying,” Carter adds. “On an after-tax basis, are you getting paid for the risk you’re taking?”
Examples like that, of course, have been created by the rising-rate environment and the market pricing in further hikes. So whether they continue will depend on how effective monetary policymakers are in curbing inflation and how much more tightening is yet to come. For his part, Carter notes that corporate bond yield spreads (the difference between corporate and “risk-free” government yields) have not yet approached the levels seen in previous periods of stress in credit markets. As well, although inflation has shown signs of peaking this summer, it is still high by historical standards, and further tightening from the Bank of Canada and U.S. Federal Reserve is widely expected this fall. That’s one reason Canso “remains pretty defensive” for now, Carter says, but it also raises the likelihood that the price declines on low-coupon pandemic-era bonds will continue. “If government yields go higher and corporate spreads go wider,” he adds, “we’re going to see even further discounts.”
The views and information expressed in this publication are for informational purposes only. Information in this publication is not intended to constitute legal, tax, securities or investment advice and is made available on an “as is” basis. Information in this presentation is subject to change without notice and Canso Investment Counsel Ltd. does not assume any duty to update any information herein. Certain information in this publication has been derived or obtained from sources believed to be trustworthy and/or reliable. Canso Investment Counsel Ltd. does not assume responsibility for the accuracy, currency, reliability or correctness of any such information.
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