… when I say “so many,” I’m sharing data from Canada’s central bank —Canadians wanting to protect their savings invested nearly $152 billion in GICs from March to November 2022 — which we know was a reaction to the rising interest rates, economic uncertainty and volatility felt everywhere. And the fact that some GIC returns have exceeded 5% was nothing to sneeze at either.
But here’s the not insignificant difference between then and now:
If what many are predicting comes to pass — if we do face an economic slowdown or go into a recession because of the rapid rise in interest rates over the last year, there is a good chance that central banks would lower interest rates.
We don’t know how low interest rates could go. But for the purposes of this blog post, let’s say they’ll go down to 3%. That means that next year, when your current GIC matures, the interest rate on your next GIC will be 40% less than what you are earning now.
Discount bonds can provide investors with an interesting alternative to GICs, and here’s why ….
- Unlike bonds GICs don’t offer investors daily liquidity, GICs are locked-in.You cannot sell them before the term is up. So if you found yourself in the scenario I described above, you’d be stuck.
- The interest income you earn on GICs is fully taxable — whereas the combination of interest (the coupon payments) and the capital gain (the difference between what you paid for the bond and the par or face value) offer a more tax-effective yield for a potentially longer period of time.
So with a discount bond, the difference between what you paid and its value at maturity provides you with a capital gain.
When we see the kind of unprecedented rapid interest rate increases we saw last year, it leads to a repricing — or discounting in other words — of bonds that were previously issued with lower coupon rates making them, in a sense, competitive with newly-issued bonds at a higher rate.
And if you’re in a high tax bracket and you’re holding the bonds in a taxable account, this can be particularly tax-effective, as compared to ordinary interest income (ie from GICs) —because capital gains are taxed at a more favourable rate. This tax efficiency can enhance overall returns and make discount bonds an attractive option for tax-conscious investors seeking to optimize their investment performance.
Here’s an example of what I’m talking about from RPIA, a Toronto-based asset management firm:
Let’s assume in January of this year, a 2-year bond was issued at $100 and is expected to return 4% (coupon rate).
Shortly after issuance, a rate hike occurred, interest rates went up, and the required rate of return moved from 4% to 6%. Therefore, the price of the bond moved down to $96.6 from $100, now yielding 6% — in order to stay competitive with newly issued bonds.
But the thing is, the price of that bond will go back up to the original $100.00 over the rest of its 2-year term. Remember that the bond was discounted just a month or two after you bought it, so the clock was not even close to running out on the term.
That extra 2% is a capital gain — not interest income — so it is not fully taxable like GIC interest is. As a capital gain it’s taxed at a lower rate and you keep more of that money. PLUS — you also get the coupon payments of 4%.
It’s really easy to see on this chart:
Now let’s compare what you get to keep with the discounted bond versus a GIC with the same value:
RPIA, ‘The Tax Efficiency of Discount Bonds. Investor Education: Bonds 101. March 2023
The numbers speak for themselves.
The yield curve is another important reason why you should consider discount bonds now.
The yield curve, published every business day by the U.S. Treasury, is considered a reliable economic indicator that has, for example, accurately predicted the last six recessions, as explained in this article in nerdwallet.
It’s a line graph that shows interest rates of bonds with different maturity dates, and the steepness and direction of the yield curve are used to gauge future interest rate changes, and the state of the economy. There’s more than one type, but for the purpose of this blog post I’m focusing on the example of an inverted yield curve, pictured below.
Image by Julie Bang ©️ Investopedia 2019
This is where we’re at currently. Short-term interest rates are exceeding long-term rates — which does indicate, as the yield curve has done many times before, that a recession may come. Which makes this a good time to consider buying discount bonds with a longer maturity date than a 1-year GIC.
- If interest rates go down, you still have a guaranteed rate until the maturity date, unlike the GIC which is now at a lower rate. You get the full par value back at maturity.
- You receive annual coupon payments.
- When the bonds reach maturity, you get capital gains.
- Capital gains have a significant tax benefit.
What’s not to love?
Make sure you don’t miss any of my posts. Follow the blog and you’ll receive email notifications every time a new post is published. See you soon.
Please note that rate of return projections are for demonstration purposes only. They are based on a number of assumptions and consequently actual results may differ, possibly to a material degree.
CIBC Private Wealth consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. The CIBC logo and “CIBC Private Wealth” are trademarks of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc. This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2023. Alan Friedman is an Investment Advisor with CIBC Wood Gundy in Toronto. The views of Alan Friedman do not necessarily reflect those of CIBC World Markets Inc. If you are currently a CIBC Wood Gundy client, please contact your Investment Advisor. Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors.
Observations 