Investors usually demand the highest return possible, but with the recent huge drop in yields in the bond market, the highest income or yield isn’t necessarily ideal from a tax perspective. Buying a “high coupon” bond that pays the investor a lot of interest up front is really only good for the taxman.

In the years ahead, taxable bond investors will have to start considering taxes and the “coupon” (or interest rate) attached to those bonds if they want the highest return after taxes. This means not necessarily buying the bond with the highest yield – and that’s a big change for bond managers and their clients.

It also means the comfortable world of watching the relative “performance” of a bond manager or bond mutual fund versus the market benchmarks (or depending on cheap and magically liquid ETFs) is about to explode into a complicated bond market mess that few professional bond managers truly understand.

You might think you are doing well, but taxation can distort returns substantially.

**A tale of two bonds**

Bonds and bond markets are a difficult subject even for those of us who work within it. To understand the topsy-turvy world of bond yields and prices, one must understand that bond prices and yields move in opposite directions. It’s an inverse relationship.

Take the example of two Canadian government bonds in the market today. One bond pays you $8 every year and gives you back $100 in 2027. The other bond pays you $1 every year and gives you back $100 in 2027. You might ask how you can have two bonds issued by the government with such different coupons. The answer is that one of the bonds was issued in 1997 when interest rates were much higher. If we gave you the opportunity to buy either of these bonds today for $100, you would pick the one giving you $8 per year (8% return versus 1%). Unfortunately, the real market doesn’t give up such opportunities.

Buyers in the market bid up the price of the $8 coupon bond and its price rises until an investor is no better off than having purchased the $1 coupon bond. Without considering the “time value of money,” the calculation is easy: An extra $7 per year for 6 years, so the 8% bond should have a price $42 higher than its 1% cousin. The price of the 1% bond is $103 so we would expect a price of $145 on the 8% bond. Doing the actual bond mathematics to the exact day and taking interest rate compounding into account, the price of the $8 coupon bond is $147 and the price of the $1 coupon bond is $103, for price differential of $44. If you trust our bond math, each bond earns you a yield of 0.5% if you hold them until maturity.

The market calls this the Canada bond yield. It’s the yield or return required by investors in the market today to lend money to the government for nearly 7 years. It makes sense. You are lending money to the same government with the same term and credit risk.

Here’s the price of these two bonds for different market yields:

If tomorrow the government started offering new 7-year bonds with yields of 2%, they would need a $2 coupon on $100 for a yield of 2%. Both the $1 coupon and $8 coupon bonds would fall in price as buyers would not accept anything less than the 2% return offered on the new bond. You would end up with the $2 coupon bond at $100, the $1 coupon bond at $94, and the $8 coupon bond at $136, all giving you a yield of 2%. This explains the fundamental inverse relationship between bond prices and yields. When one goes up, the other goes down.

**A taxing complication**

That’s all perfect for a non-taxable investor. Investors buy and sell bonds back and forth, ensuring that the yield or return on bonds of the same term and credit risk are equal. Things are not so easy when you take taxes into account.

In Ontario, the highest marginal tax rate for income is 54%. For simplicity, let’s assume the average tax rate on income is 50%. Keep in mind that under current tax law, taxes for capital gains are half of the tax rate on income, in this case 25%.

Most investors buying the 1% coupon or 8% coupon Canadian bonds yielding 0.5% assume that their final after-tax return would work out to 0.25%, exactly half of the expected yield. They have a hard lesson waiting for them when they get the tax bill.

If an investor purchased $100,000 worth of the 8% coupon bond, she would pay $9,630 in taxes over the holding period. If the investor bought the 1% coupon bond, she would pay $2,424 in taxes. Buying the 1% coupon bond would save the investor a whopping $7,205 in taxes on a $100,000 investment! Believe it or not, buying the 8% coupon bond results in an after-tax return of -1.2%. And you thought bonds were safe.

We can thank our accounting friends for this taxation sorcery. Instead of taxing a bond based on the yield it returns, taxes are applied separately to the income portion of the bond (coupons) and the principal portion of the bond (capital gain/loss). Because our government has decided on income being taxed at double the rate of capital gains, bonds with higher coupons (more taxable income) are disadvantaged. Below is a breakdown of the taxes paid on these bonds assuming a $100,000 investment is made in each of them.

With $100,000, the investor can buy approximately 97,000 in par amount of the 1% coupon bond or 68,000 in par amount of the 8% coupon bond. The difference in the number of bonds that can be purchased with $100,000 stems from the difference in prices, one bond costing $103, the other $147.

*Coupon payments for these bonds are semi-annual

**exact par amounts were 96,971 and 67,574 for the bonds

*** dirty prices for the bonds were $103.12 and $147.99 using Jan 15, 2021 settlement date

The 8% coupon bond costs the investor $17,569 in income tax while the 1% coupon bond costs only $3,151 in income tax. The investor buying the 8% bond pays $14,417 more in taxes on income!

But didn’t we just say that investing $100,000 in the 8% coupon bond would cost $9,630 in taxes? That’s quite different from the $17,569 we came to in the table. The answer to the difference comes from the tax treatment of capital gains and losses.

In the case of these bonds, which are both purchased above $100, the investor takes a capital loss when the principal is repaid. Had the bond been purchased below $100, the investor would have claimed a capital gain. A capital loss results in a tax benefit that can be calculated by multiplying the capital gain tax rate by the size of the capital loss. Keep in mind this assumes that the investor has capital gains available to offset the capital loss. If they don’t, then they will have to wait until they have realized capital gains in the future. For the sake of this exercise, we assume the investor benefits from the capital loss. The below table finalizes our tax calculations.

This is why professional investors who manage taxable bond portfolios seldom want to buy a “high coupon” bond. Since taxable investors avoid purchasing high-coupon bonds, these are cheaper and have a higher yield than their lower-coupon peers, creating a “coupon spread” between the bonds of the same issuer.

A “discount bond” (one that trades below its $100 maturity or par value), holds great attraction for the taxable investor. A bond with a much lower coupon than other bonds would be available at a discount, since it pays less upfront coupon interest. This means a buyer gets appreciation or a capital gain to compensate for the coupon shortfall.

There aren’t many discounted bonds at present. Bond yields are at generational lows, after the ultra-loose monetary policy since the Great Recession in 2008 and the even more dramatic moves by central bankers in response to the COVID-19 pandemic in 2020.

**Looking ahead**

Looking forward to when interest rates and bond yields “normalize,” there will be many discount bonds available.

Following our example of 2027 Government of Canada bonds, let’s consider a day in the future two years from now. The current yield on a 5-year Canada bond is 0.5% and the price of the Canada 1% of 2027 is $102.16. If interest rates and bond yields go back to 1.5%, where they were on approximately on December 31^{st}, 2019, the Canada 1% of 2027 price would be $97.89. If the 5-year Canada bond yield rose to 2.5%, where they approximately were at the end of 2018, the 1% of 2027 price would be $93.82.

Taking the $93.82 price, the investor would require 2% over the following 5 years but only get 1% in coupon interest per year for a total of $5 until maturity in 2027 when he gets $100 par at maturity. The other 1% would come from price appreciation. That means the investor sees his value go up $5 in 5 years for a capital gain from the $95 he paid. Since the capital gain is taxed at only 25% compared to 50% on bond coupon income, he has saved himself $2.20 in taxes. That’s a pretty powerful incentive, and should lead low-coupon bonds to increase in value compared to their higher-coupon counterparts. As taxable investors avoid higher-coupon bonds and seek discount bonds, the “coupon spreads” between high and low coupon bonds of the same issuer should grow. The higher interest rates and bond yields climb, the more the coupon spreads should widen.

**Standing alone**

The other thing we see ahead is a taxable investor preference for owning individual bonds directly instead of using pooled funds and mutual funds. A pooled or mutual fund is an entity in its own right. The investor owns units of a trust that is taxed if it doesn’t distribute its income, so most investment funds distribute their income every year.

The problem is that a trust distributes interest and dividend income, but only “realized capital gains” and not capital losses (these losses are retained in the Trust for future reduction of capital gains). This means an investor in a bond fund receives interest income but has the same tax problem. Things worked when bond yields fell and bond prices went up. The bond fund went up in value as bond prices rose. Within the fund, capital gains were taken and distributed to the unitholders.

The problem for bond fund investors comes from rising yields and falling bond prices. The average bond fund right now will fall about 8% in value for each 1% rise in bond yields. If the bond fund owns high-coupon bonds, the investor receives that interest income in the form of a distribution, with no offsetting capital loss. The taxable investor could sell units to realize a capital loss, but this still happens at a tax rate lower than the tax they paid on the bond coupon income received.

Investors won’t be very happy when their “safe” bond fund falls in value. In Canada, for example, the current yield of the Canada bond market index is 0.6%. If bond yields rise to 1.5%, where they were before the pandemic, the total return in 2021 for a bond investor will be a capital loss of 6%, only offset by 0.6% of interest income for a total return of -5.4%.

At Canso Investment Counsel, we’ve managed money for our clients for many years. We know telling an investor that their “safe” bond fund is down 5.4% will not be a pleasurable experience. Add this to the negative tax consequences of bond funds, and we think that a persistent rise in interest rates and bond yields will lead to many investors fleeing bond funds.

Nothing in the markets is ever assured, but what we are now seeing could be generational lows in interest rates and bond yields. And this is likely to lead us “Back to the Future,” with a distinct taxable investor preference to own bonds directly.

To find out more about what’s happening in the bond market, check out Canso Investment Counsel’s January 2021 Market Observer.