Park wrote: ↑
06 Aug 2017 19:11
If you're in a higher marginal tax bracket and are investing in fixed income in a taxable account, you have a problem.
What can be done?
https://www.canadianportfoliomanagerblo ... b-vs-gics/
Justin Bender points out that HBB is one solution:
"This ETF uses a total-return swap structure, which effectively converts the interest payments (which are taxed at the investor’s marginal tax rate), into deferred capital gains (which are taxed at only half the investor’s marginal tax rate, and only when the ETF is ultimately sold). Due to this advantage, HBB would be expected to have higher after-tax returns than a traditional bond ETF, like XBB"
He then goes on to show though that investing in GICs might result in a similar (possibly slightly higher) aftertax return than HBB. This is due to the fact that pretax return would be higher on GICs than HBB.
There are advantages to HBB. HBB is more liquid than GICs. If interest rates go up significantly, HBB would likely be more attractive.
There are advantages to GICs. You run the risk of the government disallowing the swap structure of HBB. As long as your GICs are backed by the CDIC, there's less credit risk with GICs. With the ETF structure of HBB, you give up the certainty of interest and return of principal that you have with GICs. The weighted average duration of HBB is 6.82 years. If you're looking to match assets to liabilities within the next 5 years, GICs would be preferable.
Another solution would be discount bonds.
There are advantages to discount bonds. Discount bonds are more tax efficient than GICs. Discount bonds may have lower costs; HBB's costs are up to 0.24%. With discount bonds, you get certainty of interest and return of principal. You can also match the duration of assets to your liabilities. You get liquidity, compared to GICs. You can choose your credit risk exposure; HBB is 43.8% AAA, 37.4% AA, 9.8% A and 9% BBB. About one third of HBB's exposure is to corporate bonds. With discount bonds, you're not exposed to the risk of the swap structure. You don't have the $100K limit of CDIC coverage; this also applies to HBB.
There are disadvantages to discount bonds. Discount bonds will be less tax efficient than HBB. The biggest disadvantage of discount bonds is that there isn't a lot of them right now, although that may change.
At present, I'm not shopping for fixed income products. But I wouldn't be surprised if GICs now and in the future would be an attractive alternative to discount bonds.
There's another advantage of discount bonds. I see fixed income as a way to bridge a cyclical stock bear market during retirement. In a cyclical stock bear market, bonds often have a negative correlation with stocks, and their price goes up. So just when I need fixed income, the value of my bonds will increase. And even better yet, that increase will be in the form of cap gains. But that won't happen to my GICs. The negative correlation in a cyclical stock bear market is also an advantage of bond funds.
In 2008, iShares funds had the following returns:
Government Bond Index 8.7%
Short Term Bond Index 8.03%
Bond Index 6.13%
Corporate Bond Index -0.59%
In 2008, Vanguard mutual fund returns were as follows:
Long Term Treasury 22.52%
Intermediate Term Treasury 13.32%
Short Term Treasury 6.68%
Long Term Investment Grade 2.29%
Intermediate Term Investment Grade -6.16%
Short Term Investment Grade -4.74%
I'd be investing in short term bonds. The negative correlation is more with government bonds than corporate bonds. And to take advantage of the negative correlation, the bonds would have to be liquid. From what I understand, provincial bond liquidity was an issue in 2008. Those who are more knowledgeable, please correct me on the last point. So I"d be looking at short term government of Canada bonds. Short term Treasuries went up 6.7% in 2008. So you probably did better in 2008 with short term Treasuries than CDs (American equivalent of GICs). But there won't be many years where short term Treasuries do better than CDs.
I think I may stick with GICs.