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Though GICs are more valuable in taxable accounts, bonds that trade at a premium have a place in registered retirement savings plans. (Thinkstock)
Though GICs are more valuable in taxable accounts, bonds that trade at a premium have a place in registered retirement savings plans. (Thinkstock)

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Bonds or GICs? For taxable investors, the choice is clear Add to ...

Usually in this space, I answer questions from readers. Now, I have a question for you.

From a tax perspective, which is better to have in a non-registered account, bonds or guaranteed investment certificates?

Careful, this is a bit of a trick question.

Some of you may be tempted to say “neither.” After all, conventional wisdom dictates that, if you own a mix of stocks and fixed-income securities, the latter are best held in a registered account to shelter the interest from tax while the stocks receive the dividend tax credit when held outside. But that rule of thumb doesn’t necessarily apply at a time of very low interest rates, as I’ve discussed before.

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Others might answer that, as long as the bonds and guaranteed investment certificates have identical yields, there’s no difference. They’re both interest-paying investments, after all, so there’s no reason to expect that the bonds would do better than the GICs, or vice-versa, in a non-registered account.

Well, it turns out that isn’t true, either.

To prove it, let’s look at an example provided by Justin Bender, portfolio manager with PWL Capital in Toronto.

“This is a significant issue that can negatively impact the portfolios of many Canadians who hold premium bonds (or bond ETFs and mutual funds) in their taxable accounts,” he writes.

Most bonds these days are trading at a “premium.” They were issued at a time when interest rates were higher, and as rates fell, the price of these bonds rose above their par value (interest rates and bond prices move in opposite directions). If you hold a premium bond to maturity, your return will consist of two parts: 1) the interest coupons you collect and 2) the capital loss that occurs as the price of the bond gradually falls back to par value at maturity.

Consider a hypothetical three-year Government of Canada bond with a coupon of 3.22 per cent and yield-to-maturity of 1.5 per cent. The yield-to-maturity is the bond’s projected return which, as noted above, is composed of the interest coupon payments and capital loss. We’ll compare this bond’s after-tax return to a three-year GIC yielding an identical 1.5 per cent, assuming both are held in a non-registered account with an initial investment of $105,000 in each.

As you can see in the table, the $105,000 government bond matures at $100,000, for a capital loss of $5,000. The investor would also collect interest totalling $9,660 over the three years ($100,000 x 0.0322 x 3). But here’s the thing: Even though the capital loss takes a big bite out of the investor’s return, the entire $9,660 in interest payments is taxable at the investor’s marginal rate (which is assumed here to be 46.41 per cent).

The tax hit works out to $4,483. If you subtract that amount, and the $5,000 capital loss, from the $9,660, in interest the investor is left with an after-tax return of just $177. True, he could theoretically use the capital loss to offset other capital gains – assuming he has them – but that would only boost the net return to $1,337, which is still pretty lousy.

Now let’s see how the GIC would have fared. (In both cases, we’re assuming the interest does not compound). At 1.5 per cent, a $105,000 GIC would pay $1,575 annually or $4,725 over three years. After deducting tax of about $2,193, the investor would be left with $2,532. So clearly, the GIC is a better option in this case.

“As a general rule of thumb, investors should avoid purchasing premium bonds, bond ETFs or bond mutual funds in their taxable accounts,” Mr. Bender writes. He adds that there is a simple way to check whether the bonds in a fund are, on average, trading at a premium: If the “weighted average coupon” is higher than the “weighted average yield to maturity,” then “you have yourself a basket of premium bonds.”

Most ETF providers list this information on their website. For example, the iShares DEX Universe Bond Index Fund (XBB-TSX) has a weighted average coupon of 4.01 per cent but a weighted average yield to maturity of just 2.22 per cent. So clearly this is a portfolio stuffed with premium bonds that would be better off in a registered retirement savings plan or other non-taxable account.

Follow on Twitter: @johnheinzl

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