Discounted Bonds vs. GICs: Maximizing After-Tax Returns

Written by Dean Moro BComm, CIM®, Financial Advisor and Associate Portfolio Manager & Carson Hamill CIM®, CRPC®, Associate Portfolio Manager and Assistant Branch Manager

In the world of investments, where maximizing returns is a primary concern for many, the choice between different financial instruments can significantly impact the after-tax yield on your portfolio. Two popular options often considered by investors are Government of Canada bonds trading at a discount and Guaranteed Investment Certificates (GICs). In this blog post, we'll explore the key differences between these two investment options and why discounted bonds can offer a superior after-tax yield.

The Income Dilemma

GICs are known for providing a steady stream of income, but there's a catch - the interest earned on GICs is fully taxable at your income tax rate. Depending on your income level, this can result in a substantial tax burden, ultimately reducing the overall return on your GIC investment.

On the other hand, bonds purchased at a discount to their par value offer a unique advantage. They come with both an income component (coupon interest) and a more favorably taxed capital gains component. This capital gains component is the difference between the discounted purchase price and the bond's par value, and it's generally taxed at a lower rate than income, making it a more tax-efficient option.

The Tax Advantage of Discounted Bonds

The capital gains component of a discounted bond is taxed at the investor's capital gains tax rate, which is typically lower than the income tax rate. This tax benefit means that you get to keep more of your return on the bond, leading to a higher after-tax yield.

The coupon interest component of a bond is taxed at your income tax rate, similar to GICs. However, because discounted bonds also include the more tax-efficient capital gains component, the overall tax burden may be lower than that of a GIC. This can result in meaningfully different after-tax yields, even when the investment levels are comparable.

In Canada, only half of the capital gain is taxed as income. It’s a bit more complicated for US persons in Canada, because they also have to file a US return, but often there are benefits to capital gains as well.

The Current Interest Rate Environment

The rising interest rate environment in 2023 has presented a great opportunity to take advantage of this strategy. Many bonds issued prior to 2023 with low coupon rates are trading at discounts to par. When you purchase deeply discounted bonds with low coupon rates, a large portion of your overall return will be a capital gain. In a taxable account, the realized after-tax return on a discounted bond can be significantly higher than the after-tax return on a GIC with an equivalent yield to maturity.

Discounted Bond vs. GIC Example

The chart below demonstrates the tax benefits of a discounted bond versus a GIC in a taxable account by utilizing a 50 per cent interest income tax rate and a 25 per cent capital gain tax rate. All clients will have a tax rate that is unique to them; these calculations are merely for illustrative purposes.

* For illustrative purposes only. Data as of January 15, 2024.

The Pros of Discounted Bonds

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

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

• Potential for Capital Gains: In a downward-trending interest rate environment or as the bond approaches par value, investors may realize capital gains before the bond reaches maturity.

The Cons of Discounted Bonds

However, it's essential to consider the downsides of bonds 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, so it's crucial to stick to high-quality issuers to minimize this risk.

• Price Fluctuations: Bond prices are constantly changing, which can be a double-edged sword. While they can increase in value, they can also decrease, leading to potential losses if sold before maturity.

Summary

While GICs provide regular income, discounted Government of Canada and corporate bonds can offer higher after-tax returns in non-registered and corporate accounts due to their tax advantages, and they are generally more liquid. The combination of income and capital gains components in bonds, along with their lower tax rates, can lead to significantly better after-tax yields. However, it's crucial to weigh the pros and cons and consider your financial goals and risk tolerance when making investment decisions. Ultimately, choosing between GICs and discounted bonds depends on your individual circumstances and investment objectives.

Next Steps

If you’re planning on moving to Canada and need assistance with your investments, estate planning, and portfolio management, please contact Snowbirds Wealth Management as we specialize in cross-border financial planning and wealth management. We work closely with experienced cross-border lawyers and accountants to ensure you have a team behind you.

About Snowbirds Wealth Management

Gerry Scott is a portfolio manager and founder of Snowbirds Wealth Management, an advisory firm focussed on the cross-border market. Together with Dean Moro and Carson Hamill, associate portfolio managers with Snowbirds Wealth Management, they provide investment solutions for Americans living in Canada, and Canadians residing in the United States. Licensed in both Canada and the US, they provide tailored investment solutions to minimize the tax burden when moving assets across borders.

To schedule an introductory call, please click here.

Statistics and factual data and other information are from sources RJLU believes to be reliable but their accuracy cannot be guaranteed. It is for information purposes only and is not to be construed as an offer or solicitation for the sale or purchase of securities nor is it meant to replace legal, accounting, taxation or other professional advice. We are not tax advisors and we recommend that clients seek independent advice from a professional advisor on tax-related matters. The information is furnished on the basis and understanding that RJLU is to be under no liability whatsoever in respect thereof.

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