Key takeaways:
- Discount bonds are bonds that pay regular coupon interest and currently trade at a price below their par value.
- Yield to Maturity on discount bonds are comparable to the broader market
- Discount bonds can provide a more tax-efficient return in non-registered accounts when compared to bonds purchased at par or GICs
- Discount bond ETFs can provide exposure to a diversified portfolio of high quality, short- term government and corporate discount bonds.
When choosing a fixed income solution, yield is often the first thing that comes to mind. After all, investors want to know what they can expect to earn from their investment. But there are other important factors that can impact the return you receive from your fixed income portfolio. These include duration, liquidity, price, credit risks and associated costs.
For non-registered accounts, taxes are also a key consideration.
Understanding discount bonds
When a company issues a bond, it’s generally priced at what is known as par value, usually $100.
After a bond is issued, it can be traded. As interest rates change, the trading price of a bond will also change. Shifts in interest rates can have a significant influence on bond prices and yield to maturity.
For example, when interest rates rise, the market expects higher returns on their bond investments. This pushes the prices of bonds down, while its yield to maturity (coupon interest plus capital gain upon maturity) rises. If a bond is trading below its par value, it’s called a discount bond. A bond trading above its par value is called a premium bond.
Interest rates and bond prices have an inverse relationship
The key benefits of discount bonds
Discount bonds provide all the traditional benefits of bonds. They provide a predictable source of income, help preserve capital, and add attractive diversification benefits to an investment portfolio as fixed income tends not to move in the same direction as other asset classes.
Discount bonds can also provide enhanced tax-efficiency. Since a discount bond is purchased below par value, investors have the potential to earn not only regular coupon or interest payments, but also a capital gain when the bond matures. In non-registered accounts, the tax-efficiency comes from the capital gains, which in Canada are taxed at half the rate of interest income.
Discount bonds are different than other types of discount instruments such as T-bills, strip bonds, strip coupons, banker’s acceptance notes and commercial paper. These latter instruments don’t pay regular coupon interest and, as a result, the increase in value of these instruments is taxed as income rather than capital gains.
An example
Compare the taxes due on two similar bonds, one selling at a discount and the other at par. Both have one year to maturity, the same 5% yield-to-maturity and a par value (or maturity value) of $100. The discount bond delivers a mix of capital gains and interest, resulting in a higher after-tax yield to maturity.
| Discount Bond | Par bond/GIC | ||
|---|---|---|---|
| Price paid (par value $100 | $98.10 | $100 | |
| Coupon rate | 3.00% | 5.00% | |
| Pre-tax yield to maturity | 5.00% | 5.00% | |
| Interest income | Capital Gain | Interest income | |
| Total income/gain/loss | $3.00 | $1.90 | $5.00 |
| Taxes (50% marginal rate) | -$1.61 | -$0.51 | -$2.68 |
| After-tax income | $1.39 | $1.39 | $2.32 |
| Total after-tax income | $2.78 | $2.32 | |
| After-tax yield to maturity | 2.82% | 2.32% | |
For illustrative purposes only. Source: RBC Global Asset Management. Based on 2023 Ontario Tax Rate of 53.5%, capital gains inclusion of 50%
As most investors know, it’s not what you earn, but rather it’s what you keep that matters.