Why GICs Beat Bond ETFs in Taxable Accounts

Last October, Justin Bender wrote a blog post explaining why GICs are more tax-efficient than bonds. The blog caught the attention of John Heinzl of The Globe and Mail, who wrote his own article on the topic a month later. Many investors are still surprised and confused by this idea, however, so I thought it was time to take another look.

It’s true that bonds and GICs are taxed in the same way. If you buy a newly issued bond with a face value of $1,000 and a coupon of 4%, you’ll receive $40 in interest each year, and this amount is fully taxable at your marginal rate. If you buy a $1,000 GIC yielding 4%, the situation would be identical. Nothing complicated so far.

However, in practice, things aren’t that simple. Interest rates have been trending down for years, and bonds issued when rates were higher now trade at a premium. Let’s use an example to explain this concept. Twelve months ago you bought a five-year bond with a face value of $1,000 and a coupon of 4%. Since then interest rates have fallen one percentage point. That means your bond now has four years left to maturity and is still paying $40 in interest, while new four-year bonds are paying just 3%, or $30. If another investor was in the market for a four-year bond today, which one would he want?

The answer is obvious: he’d want the bond paying more interest. But we know there’s no free lunch. The bond with the 4% coupon will now sell for a premium: it would be valued at approximately $1,036. (I’m simplifying the math here, because the concept is what’s important.)

Now there’s a trade-off: the buyer of your old bond will receive more interest, but at maturity he’ll collect only the face value of $1,000 and suffer a capital loss of almost $36. If both bonds are held for the full four years, their total return will be the same: in other words, both now have a yield to maturity of 3%:

Premium bond Bond at par
Term to maturity 4 years 4 years
Face value $1,000 $1,035.71
Price (initial investment) $1,035.71 $1,035.71
Coupon 4% 3%
Yield to maturity 3% 3%
Interest paid over four years $160.00 $124.29
Capital loss at maturity -$35.71 $0.00
Total return (interest–capital loss) $124.29 $124.29

The upshot is if you’re investing in your RRSP or TFSA, it doesn’t matter whether you buy bonds at a premium, at par, or at a discount. With no taxes to pay, it all comes out in the wash.

Taxes change everything

If you’re holding fixed income in a non-registered account, however, the situation is quite different. The reason is that interest and capital gains/losses receive different tax treatment. And when you buy a premium bond, a greater share of your total return comes from fully taxable interest. Here’s an example using the same two bonds as above, and assuming the investor’s marginal tax rate is 40%:

Premium bond Bond at par
Term to maturity 4 years 4 years
Face value $1,000 $1,035.71
Price (initial investment) $1,035.71 $1,035.71
Coupon 4% 3%
Yield to maturity 3% 3%
Interest paid over four years $160.00 $124.29
Net interest after tax (40%) $96.00 $74.57
Capital loss at maturity -$35.71 $0.00
Total return (net interest–capital loss) $60.29 $74.57

If you could subtract the $35.71 loss from the premium bond’s $160 in interest payments, then both bonds would deliver the same after-tax return. But you can’t do that: a capital loss can only be used to offset a capital gain, not to reduce interest income. Capital gains are taxed at only half your marginal rate, so in the above example, the investor who used the loss to offset a gain would save only $7.14 in taxes ($35.71 x 20%). That would bring his total after-tax return to $67.43—still a lot less than the bond purchased at par.

Remember, too, that tax on the interest is payable every year, while the capital loss can only be claimed after it is realized when the bond matures four years down the road.

Par for the course

So what does all this have to do with GICs and bond ETFs? The key point is that GICs never trade at a premium or discount to their face value. Unlike bonds, GICs don’t trade on the secondary market—you can’t buy a five-year GIC today and sell it to someone else at a premium next year if interest rates fall. As with a bond purchased at par and held to maturity, a GIC’s total return is made up entirely of interest, with no capital gains or losses. Its coupon and its yield to maturity are always the same.

Compare that with bond ETFs today: virtually every one is filled with premium bonds. You can see this by visiting the fund’s web page, where you will notice that its coupon is higher than its yield to maturity. In some cases, the difference is dramatic, as with the iShares 1-5 Year Laddered Government Bond (CLF):

 CLF

This ETF would be much less tax-efficient than a five-year GIC ladder, because that entire 4.27% coupon (minus fees) is fully taxable, even though the yield to maturity is just 1.32%. What’s more, GICs pay higher yields than government bonds: today you can build a five-year ladder with an average yield over 2%, with no credit risk and no chance of a capital loss.

ETFs do offer more liquidity than GICs, and there’s an opportunity for capital gains if rates fall and you sell the fund after its price has gone up. But if you’re a long-term investor who needs to hold fixed income in a taxable account, GICs are likely to be a better choice.

111 Responses to Why GICs Beat Bond ETFs in Taxable Accounts

  1. Brian May 9, 2014 at 11:11 am #

    Hi CCP, I enjoy reading your articles. Recently, I can across this article and I am not sure I totally agree or understand this article. And I afraid it can be misleading for some investors to completely move to a GIC ladder to replace Bonds. Maybe the numbers worked in 2013 but I dont think your high level advice is correct. I do not think investing in GIC in taxable accounts are better than bonds – at least in terms 3 year or longer. The GIC rates are just not “high” enough. ( I do agree with you for a 1 year term and probably 2 year term. )

    I quickly did the math comparing $5K in a 4 year BBB corporate bond to a compound 4 year GIC. Bond came out ahead – even without using the capital loss credit. In fact, I would suggest that you can invest the additional income you receive from the bond each year so you can potentially achieve more growth over the 4 years or just spend the extra income.

  2. Canadian Couch Potato May 9, 2014 at 11:56 am #

    @Brian: There may be specific instances where a given bond comes out ahead, but it doesn’t change the fact that GICs are more tax efficient than premium bonds with equivalent yields. In your comparison, the risk level is different. A GIC is a guaranteed investment with no credit risk: a corporate bond is not. So if the corporate bond delivers a higher return it is because it pays a higher yield due to additional risk.

  3. Jas July 12, 2014 at 1:38 pm #

    @CCP:
    Is it possible most advisers don’t seems to be aware of the tax inefficiency of regular bonds ETF/mutual fonds? I’ve seen many friends/colleagues with portfolio managed by financial advisors from different horizon (major canadian banks, MD management, private advisors ,etc.) that include a big portion of their fixed income investments within taxable accounts using mutual funds and/or bonds ETFs

    Beside the few “tax friendly” special bond ETFs that you have written about on this blog (BXF,ZDB, HBB), are you aware of any other bond mutual funds (active or passive management) that try to solve the problem of the tax inefficiency due to premium bonds?

  4. Canadian Couch Potato July 12, 2014 at 6:57 pm #

    @Jas: I don’t think there is any question that many advisers are unaware of the tax inefficiency of funds that hold premium bonds. We see these tax-inefficient funds held in non-registered accounts all the time. I have also noticed many advisers don’t like GICs: I think they consider them to stodgy.

    In addition to the specialty ETFs you mention, DFA funds are also quite tax-efficient because they hold primarily low-coupon bonds.

  5. Jas July 13, 2014 at 2:07 pm #

    @CCP:
    Should we expect so-called “Tax effective funds”, such as Mawer Tax Effective Balanced fund, to hold low-coupon bonds instead of premium bonds? Or maybe this a unique feature of DFA’s fixed income funds?

    You explain how one can assess an ETF’s information page to screen for the presence of premium bonds with the difference between “Coupon” and “Yield to maturity”. Is this information also available for mutual funds?

    http://www.mawer.com/mutual-funds/fund-profiles/mawer-tax-effective-balanced-fund/

  6. Canadian Couch Potato July 13, 2014 at 2:39 pm #

    @Jas: DFA is not unique in its efforts to tax-manage their funds. From the description on the PDF (“the manager minimizes taxes through the application of a tax overlay strategy, with the objective to minimize taxable distributions”) it sounds like Mawer is doing something similar. Unfortunately mutual funds aren’t very forthcoming with the specifics. We only learned about the tax advantage of the DFA fixed income fund when Justin complied all the distribution information manually and crunched the numbers.

  7. Jas July 15, 2014 at 6:12 pm #

    Here is what I found inside Mawer’s tax effective balanced fund annual management report
    (from sedar.com database):

    “Bonds are used primarily to control risk. Bonds are chosen with a view to the appropriate term, credit quality, and issuer depending upon the expected direction of interest rates, the interest rate spreads between different sectors of bonds, and the expected state of financial conditions for the issuer. Bonds trading near par or at a discount are preferred, all else being equal, given their better tax efficiency versus premium bonds.”

    So this confirm they prefer low-coupon bonds to premium bonds for their “tax efficient” fund.

  8. Susan_S September 14, 2014 at 11:18 am #

    Does the recent arrival of Horizons Canadian Select Universe bond ETF (HBB) dramatically change this discussion? (I am trying to figure out whether to use GICs or HBB in a taxable account.)

  9. Canadian Couch Potato September 14, 2014 at 5:29 pm #

    @Susan: HBB is certainly more tax-efficient than traditional bond ETFs. You just need to be comfortable with the counterparty risk inherent in any swap-based ETF, and the possibility that in the future the government may decide to put an end to this structure. Note that BMO’s new Discount Bond ETF is also an alternative to GICs in taxable accounts.

    http://canadiancouchpotato.com/2011/06/08/swap-based-etfs-what-are-the-risks/
    http://canadiancouchpotato.com/2014/05/08/a-tax-friendly-bond-etf-on-the-horizon/
    http://canadiancouchpotato.com/2014/02/13/new-tax-efficient-etfs-from-bmo/

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