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Today’s billion-dollar mistake in Canadian fixed income

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People invest in bonds because they don't want to lose money. But the problem is that many investors are not paying attention to the after-tax returns of their bond investments. Today, there are negative expected after-tax returns on billions of dollars of corporate bonds in Canada.

If financial market history serves as a guide, what worked in the past will not necessarily work in the future. Many short-term bond investments (individual bonds, mutual funds and exchange-traded funds), are at risk of not working as one would expect. Here's why:

In fixed income, the "yield to maturity" is the return the investor receives over the term of the investment, expressed as an average annual percentage rate. This return is a combination of two things: the expected price appreciation (or depreciation), and the interest income produced by the investment.

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So how do taxes come into the picture?

Income payments are taxed at the investor's marginal rate, whereas capital gains are taxed at half of the investor's marginal rate. In order to minimize investor taxes, an investor should want as little return as possible to come from income since earning returns through capital gains are much more attractive. Unfortunately, we are currently seeing interest income on bonds that is high enough to turn a positive before-tax investment into an after-tax money loser.

To illustrate how this happens, take a bond index used for a popular short-term bond ETF that has approximately $1-billion in assets. As of May 31, this index had an average interest payment of 2.5 per cent a year, yet the index had a yield to maturity of 1.15 per cent, with an average maturity of three years. What this means is that investors can expect an average annual pretax return of 1.15 per cent over time. However, at top marginal tax rates, annual taxes owing on the 2.5 per cent of interest income would take away about 1.25 per cent of return, making it a negative after-tax return of minus 0.1 per cent (1.15 per cent less 1.25 per cent in taxes), even though the advertised "yield" would indicate the product should earn a positive return.

If investors choose to hold this investment for three years, they are virtually guaranteeing a loss in after-tax dollars. What is most astonishing is that this negative result is before an ETF's management expense ratio and, if the investor pays for investment advice through a financial adviser, an additional investment advisory fee.

The sales pitch du jour seems to be "we charge less." Indeed, fair fees should be an important focal point for investors; however, there is a limit to the value of low fees particularly when a product is no longer set up to achieve an investor's goal. As the above tax dynamics demonstrate, after-tax risk-adjusted returns should be an investor's primary focus. This must consider fees, but not be defined by them.

But what is a conservative alternative? Invest in an actively managed bond fund that avoids the use of leverage and is designed to provide: 1) stability of value, 2) portfolio diversification and 3) after-tax returns that are reasonable relative to the investment risk taken.

One final consideration is regarding alignment of interests. Fixed income funds often fail to consider tax implications because the fund's assets are composed primarily of tax-exempt institutions such as pensions and endowments. Understandably, this leads to before-tax evaluation of investments in the portfolio-construction process. For taxable investors, finding a fixed income manager whose incentives and investor base are well aligned from a tax perspective can be as important as the strategy itself.

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Randy Steuart is the portfolio manager of the Flexible Fixed Income Fund at investment firm Ewing Morris & Co. in Toronto.

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