August 27, 2012

Making Your Bonds Work Harder

Recent global stock-market and economic turmoil have highlighted bonds as a safe haven for investors, but this enthusiasm has also contributed to historically low interest rates.  As increasing demand pushes the price of bonds up, the yield falls.  This low-rate environment makes it difficult for individuals to draw a reasonable income from their investments without assuming higher risk.  With interest rates expected to remain low, some investors are considering higher yielding stocks to meet their income needs … but at what risk?  In some cases the tradeoff is warranted; however, investors should first ask, “How can I make my bonds work harder?”

Here are three suggestions: 

1.      Where do you own your bonds?

Many high-income Canadians take advantage of registered savings plans and everyone should consider a Tax Free Savings Account (TFSA).  Unfortunately, many investors do not take full advantage of the benefits of such accounts.  A major factor in the decision to invest in stocks versus bonds hinges on the return the investor seeks, adjusted for their tolerance for losing money in the short term.  The result is an asset mix that will meet their longer term goals (eg. a certain level of income or growth) but most investors stop the process at this point.  However, as many investors look to their registered accounts or TFSAs in retirement to fund lifestyle expenses, they should consider a stable source of income to fulfill this need (i.e. bonds).  By allocating bonds to their registered or TFSA accounts, the investor will defer or shelter the interest income that bonds produce while creating more room to own stocks in taxable or non-registered accounts.  By allocating stocks to taxable accounts, the investor will benefit from the preferred tax rates on capital gains and the dividend tax credit on eligible Canadian dividends.

2.      Beware of the high coupon bond

Due to the decline in interest rates, the majority of bonds are trading over the price at which they mature, since interest rates and prices move in opposite directions.  This is important to investors since the “taxman” treats coupons much like employment income with no adjustment for the premium paid to get the high coupon.  Therefore, the tax effect is much worse than a similar bond with a price near its maturity value.  Using the example of an investor in the top marginal tax bracket, you would be surprised to find that a Nova Scotia Power bond with a 9.75% coupon maturing in 2019 and a current price of $142 generates an after-tax return similar to a Government of Canada bond with a 1.5% coupon maturing in 2017 with a current price of $100.  With less interest rate risk and without risk of default, this latter investment option seems like the better opportunity.  That is why it is important to have your manager find the best opportunities by considering the after-tax return of bonds held in taxable accounts as part of the selection process.

3.      Consider preferred shares

Another investment option that investors should consider for their taxable accounts are preferred shares. These investments are a hybrid of bonds and equities.  Like bonds, they pay a fixed coupon. However, like equities, the income they pay is treated as dividend income, allowing investors to claim the dividend tax credit that eligible Canadian dividends enjoy.  Although this seems like a combination of the best features of both equities and bonds, investors should remember that unlike bonds, preferred shares do not have a fixed maturity date and rank behind bonds in priority of payment.  These factors are important to keep in mind when evaluating the merits of these investments.  That said, a carefully structured portfolio of both bonds and preferred shares can provide a relatively safe and tax-efficient source of income. 

While investors are confronting the hard reality that bonds will no longer provide the same safe, high single digit returns they have enjoyed for the last 30 years, bonds remain an important investment option.  They generate regular income and provide stability to a portfolio, while moderating some of the volatility inherent in the equity markets.  So before jumping off the bond band-wagon, first ask the question, “How can I make my bonds work harder?”

This article is not intended to provide advice, recommendations or offers to buy or sell any product or service.  The information provided is compiled from our own research that we believe to be reasonable and accurate at the time of writing, but is subject to change without notice.

Andrew Hoffman

Principal, Portfolio Manager - Private Clients & Foundations