GIC Ladder Questions

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NOVICE99
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GIC Ladder Questions

Post by NOVICE99 » 15 Apr 2006 14:16

Which one will provide higher returns over a 10 year timeframe? How does a bond ladder get taxed? I know GIC interest gets taxed annually. Which one is better in a bear market?

Please if possible give me some advantages or disadvantages of each, and what is the wiser option at this time?

Can I build a bond ladder with global bonds and where do I find them? Or where can I open a GIC in a foreign currency? Don't have lots of money so can't do this direct; need brokerage help.

Thanks.

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Post by patriot1 » 15 Apr 2006 14:32

The only real difference between a bond and a GIC is that a bond is marketable, while a GIC may be cashable (lousy rate) or not cashable. Also a coupon bond will pay you interest in cash (but a strip bond won't), while a GIC may have cash payments or may compound.

A side effect of this is that the market value of a bond will fluctuate, while that of a GIC will not. Don't be fooled - this makes no difference unless you sell the bond before maturity.

There is no difference in the tax treatment of interest - it is taxable annually whether you receive it or not.

One caveat - NEVER buy a bond in a taxable account at a price above 100 (i.e. above face value).

As for foreign bonds, it's easy enough to buy US$ bonds (why anyone would want to is another question). Other currencies would probably have high overheads. Just maybe banks like HSBC might sell foreign currency GIC's.

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Re: Bond ladder vs GIC ladder?

Post by Norbert Schlenker » 15 Apr 2006 14:38

Assuming that durations match approximately, the returns will be pretty comparable. Choosing one over the other is more a matter of simplicity, credit quality, and an illusion of stability in portfolio value, with GICs usually getting the nod for small amounts.

With bonds, you pay tax on the coupons as you collect them. (There's a deduction for any accrued interest you pay at purchase.) It's no different than taxes on GICs.

Brokers carry global bonds but usually don't market them widely. If you use a discount broker, you're almost never going to see an inventory of anything like this. Calling on the phone is the only way. Foreign currency GICs - other than US$ - are very scarce. Last time I looked, HSBC had some at derisory rates. With not much money, it may be better to just stay away. You're going to get raped on spreads and FX.
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Post by scomac » 15 Apr 2006 15:26

patriot1 wrote:
One caveat - NEVER buy a bond in a taxable account at a price above 100 (i.e. above face value).
Why not?
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Post by like_to_retire » 16 Apr 2006 08:03

Why not?
When you purchase a bond at a premium, you're required to give up after tax dollars to purchase the premium (discounted by the YTM), that is then subsequently metered back to you as a portion of each coupon over the life of the bond. No problem there, but of course you'll pay full interest income tax each year on these premium returns - basically paying tax at 'income' rates twice on a portion of your return.

On disposition of the bond at maturity, you are able to deduct this premium (that you've paid taxes on), but only as a 'capital' tax loss and not as an 'income' tax loss.

Personally, I will buy bonds at a premium in my open account, but I have an upper limit.

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Post by scomac » 16 Apr 2006 08:59

I was aware of the discrepancy in taxation when purchasing bonds at a premium, however this assumes that two bonds of the same maturity and the same credit quality will have the same YTM regardless of whether or not the bonds are selling at a premium/par/discount to par. In actual practice, this doesn't seem to exactly play out that way in the retail market (in my limited experience).

The first reference I heard of using a strategy of buying premium bonds was in reference to John Kellett of RBC. He used to do this on a routine basis to improve the tax efficiency of the RBC (then Royal) Dividend Fund. His argument was that as long as the cashflow from the bond met his minimum, he would buy a bond at a premium. The capital loss upon maturity was then used to off-set capital gains in the equity portfolio.
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Post by AltaRed » 16 Apr 2006 10:34

I suspect market pricing *might" take some of the difference in taxation away, but I sure would not trust that opinion. Which is why my expiring strip bonds (in my RRSP) from years ago are being replaced with 5 year GIC ladder.

For me, it is the principle of the thing. I cannot fathom paying a premium on a bond just so I can obtain higher interest taxed at full marginal rates and then get to claim a capital loss somewhere down the road at 50% rates. That feels very much like standing in the center lane of a freeway.

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Post by like_to_retire » 16 Apr 2006 12:12

But in an RSP, it matters not whether it's a premium or a discount bond.

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Post by jiHymas » 16 Apr 2006 12:57

scomac wrote: was aware of the discrepancy in taxation when purchasing bonds at a premium, however this assumes that two bonds of the same maturity and the same credit quality will have the same YTM regardless of whether or not the bonds are selling at a premium/par/discount to par. In actual practice, this doesn't seem to exactly play out that way in the retail market (in my limited experience).
There used to be a quite significant yield pick-up for high-coupon issues in the Canadas market. Then, sometime around 1996, I think, the Bank of Canada introduced rules to make coupons fungible on the reconstitution of bonds (e.g., you could buy a high-coupon bond, strip it, then use the coupons to reconstitute a low-coupon bond). They also commenced buy-backs of old, illiquid issues ... much of the yield premium was due to liquidity concerns.
scomac, emphasis by jiHymas wrote:The first reference I heard of using a strategy of buying premium bonds was in reference to John Kellett of RBC. He used to do this on a routine basis to improve the tax efficiency of the RBC (then Royal) Dividend Fund. His argument was that as long as the cashflow from the bond met his minimum, he would buy a bond at a premium. The capital loss upon maturity was then used to off-set capital gains in the equity portfolio.
May I presume that by "minimum" is meant the amount of interest required to offset the MER?

Such a strategy makes perfect sense from a tax-efficiency perspective, since otherwise you're paying the MER with dividends, losing the tax-advantage.

Of course, this only ultimately makes sense if you're not bullish on the stocks in your mandate. If your choice is between a stock paying 2% dividend and a bond paying 6% coupon, yielding 5% to pay your MER, then of course you choose the bond - you tie up less capital. If, however, your expectation is for the stock to provide a capital gain of, say, 5%+, then the best strategy is not so clear.
like_to_retire wrote:But in an RSP, it matters not whether it's a premium or a discount bond.
Or in a pension fund.

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Post by scomac » 16 Apr 2006 13:57

jiHymas wrote:
scomac, emphasis by jiHymas wrote:The first reference I heard of using a strategy of buying premium bonds was in reference to John Kellett of RBC. He used to do this on a routine basis to improve the tax efficiency of the RBC (then Royal) Dividend Fund. His argument was that as long as the cashflow from the bond met his minimum, he would buy a bond at a premium. The capital loss upon maturity was then used to off-set capital gains in the equity portfolio.
May I presume that by "minimum" is meant the amount of interest required to offset the MER?

Such a strategy makes perfect sense from a tax-efficiency perspective, since otherwise you're paying the MER with dividends, losing the tax-advantage.

Of course, this only ultimately makes sense if you're not bullish on the stocks in your mandate. If your choice is between a stock paying 2% dividend and a bond paying 6% coupon, yielding 5% to pay your MER, then of course you choose the bond - you tie up less capital. If, however, your expectation is for the stock to provide a capital gain of, say, 5%+, then the best strategy is not so clear.
James,

I never thought of it in those terms, but it does make absolutely crystal clear sense to own precisely enough in interest baring investments to off-set the total management fee of the portfolio. This would allow the quarterly distributions to be made up of dividends and realised capital gains. 8)

What attracted me to this particular strategy was the fact that by buying high coupon bonds (selling at a premium), I could manufacture greater cashflow without taking on any additional risk. In theory, I would be penalized from a tax perspective, but it isn't nearly that cut and dried in actual practice due to bond pricing discrepancies. This discrepancy has lead me to conclude that the bond market must be actually trying to account for some of the difference in yield in an after tax basis. While the pension funds aren't affected by taxation, aren't the considerable holdings of insurance companies used to defease future liabilities taxed?
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Post by AltaRed » 16 Apr 2006 14:40

like_to_retire wrote:But in an RSP, it matters not whether it's a premium or a discount bond.
Agreed and could potentially even be advantageous if the market slightly depresses the premium because of the inherent disadvantage in taxable accounts. However, the word 'premium' sounds almost perverse and doesn't help me sleep at nights.

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Post by patriot1 » 16 Apr 2006 15:32

this assumes that two bonds of the same maturity and the same credit quality will have the same YTM regardless of whether or not the bonds are selling at a premium/par/discount to par
Given that most Canadian bonds are held by non-taxable entities, I would expect this. If a premium bond had a higher YTM I would expect the non-taxable market to bid its price up - or bid down the non-premiums.

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Post by scomac » 16 Apr 2006 15:46

patriot1 wrote:
this assumes that two bonds of the same maturity and the same credit quality will have the same YTM regardless of whether or not the bonds are selling at a premium/par/discount to par
Given that most Canadian bonds are held by non-taxable entities, I would expect this. If a premium bond had a higher YTM I would expect the non-taxable market to bid its price up.
This doesn't seem to be the case in actual practice. As an example let's compare three bonds of equal credit quality and maturity with differring coupon rates.

A) 4%; B) 4.5%; C) 5%

If we assume that these bonds mature in 10 years and the current yield for such investments is 4.5% YTM, then the market price of these bonds would be:

A) $89.89; B) $100.00; C) $111.11

These are the theoretical valuations and yet, based on my research about a month ago, the discount and premium would be about half the theoretical discount/premium.

We assume, in Canada, that most bonds are held in tax deferred accounts, yet when looking at actual bond market pricing it's pretty evident that there are forces at work trying to equalize valuations for those bonds held in taxable accounts. This would lead me to conclude that the taxable market for bonds is quite a bit bigger than we realise.
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Post by like_to_retire » 16 Apr 2006 18:42

A) 4%; B) 4.5%; C) 5%

If we assume that these bonds mature in 10 years and the current yield for such investments is 4.5% YTM, then the market price of these bonds would be:

A) $89.89; B) $100.00; C) $111.11
A bond settling in ten years with a par value of 100.00 and a coupon rate of 5.00%, and a market yield of 4.50% will be priced at $103.99 and not $111.11.

A bond settling in ten years with a par value of 100.00 and a coupon rate of 4.00%, and a market yield of 4.50% will be priced at $96.01 and not $89.89.

Hopefully, your figures were for demonstration purposes?

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Post by scomac » 16 Apr 2006 22:27

like_to_retire wrote: Hopefully, your figures were for demonstration purposes?

ltr
Nope, that was just total garbage on my part. :oops: That's what happens when you're doing three things at once and quickly copy some scribblings off of a sheet of paper. :roll: I realised my mistake earlier this evening and went about to recalculate coming up with the exact figures you presented. It appears that the figures I posted up thread would be the pricing necessary to generate compareable cash-on-cash yields.

Simply put, for the retail investor not paying investment management fees, much of Kellett's implied tax advantage (from buying premium bonds) is lost. You can generate a better cash-on-cash yield with high coupon bonds, but the trade-off is poorer tax efficiency. Consider myself now better educated on the matter.
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Post by jiHymas » 16 Apr 2006 23:50

patriot1 wrote:
this assumes that two bonds of the same maturity and the same credit quality will have the same YTM regardless of whether or not the bonds are selling at a premium/par/discount to par
Given that most Canadian bonds are held by non-taxable entities, I would expect this. If a premium bond had a higher YTM I would expect the non-taxable market to bid its price up - or bid down the non-premiums.
Another factor is liquidity.

In today's market, 'higher coupon' is virtually synonymous with 'earlier issued' ... and 'earlier issued' often means 'has had time to find a good home with buy-and-hold investors'.

When tradable quantities of bonds fall below $1-million, market efficiency declines quickly.

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Higher risk fund to offset GIC ladder?

Post by rigpig » 02 May 2006 20:47

I sold all my mutual funds and set up a GIC ladder at Achieva. So now all of my RSP is in fixed income, except 15% which is in a locked in plan where my employer matches my contribution of 5% of earnings. It is currently in a "medium risk" balanced fund that's been giving me 10%.
I have a choice of 2 funds per risk group - high/med/low.

My question is if I'm not going to touch this money for 20 years would it be a good strategy to pick a fund in the high risk group for growth, to offset the no-growth of my ladder?

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Re: Higher risk fund to offset GIC ladder?

Post by NormR » 02 May 2006 23:55

rigpig wrote:I have a choice of 2 funds per risk group - high/med/low.

My question is if I'm not going to touch this money for 20 years would it be a good strategy to pick a fund in the high risk group for growth, to offset the no-growth of my ladder?
Err, just what is a risk group?

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Post by rigpig » 03 May 2006 00:18

group: meaning a number of funds as in more than one.

I have a choice of:

Canadian balanced (4 funds) - medium risk LLIM/AGF/Dynamic/Trimark
a dividend and large cap - medium risk LLIM
Canadian equity (2 funds) - medium to high risk Dynamic/Trimark
a small and mid cap - high risk AGF
a money market bond - low risk LLIM
a mortgage - low risk LLIM
a US equity - medium risk LLIM
a global equity - high risk Trimark
international equity- high risk JP Morgan

Right now it's in the Canadian balanced and I was pondering moving it to a higher risk fund seeings as I have adequate fixed income with my GIC's.
Last edited by rigpig on 03 May 2006 00:29, edited 1 time in total.

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Post by NormR » 03 May 2006 00:22

which funds?

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Post by rigpig » 03 May 2006 00:36

I edited the post above.

I'm trying to get a list of the MER's to try and help me decide between the dividend large cap or the small and mid cap, then I thought maybe I should have some exposure to Global and International but their past performance hasn't been that hot.
I would prefer to have a choice of ETF's or at least a couple index's but I don't. I'm also not crazy about paying a MER but I have no choice here.

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Post by randomwalker » 03 May 2006 19:35

Not to be taken in any way as any kind of a recommendation but if one wanted to look at "high risk funds" one might want to check out Horizons BetaPro Funds which allow the "investor" to make leveraged "investments" (bets is perhaps a better discription) on the rise or fall of gold, oil, the dollar, interest rates and some stock indexes.

http://www.hbpfunds.com

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Post by rigpig » 03 May 2006 20:40

I can't - I'm stuck with the above listed mutual funds. I've narrowed it down to either the Trimark Global or the JP Morgan International. I think?

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How to ladder GICs based on BoC rate forecast?

Post by NOVICE99 » 02 May 2007 09:54

Guess I didn't go this right the 1st time ... have a bunch of GICs all maturing in July-Sept of this year. So I was reading about the BoC rate forecasts by RBC and Scotiabank (different opinions?) at

http://www.scotiacapital.com/English/bn ... recast.pdf

http://rbcnet.fg.rbc.com/economics/cid-44147.html

and hoping that someone here can kindly educate me what this means in terms of reinvesting in 5-year GICs.

Do I look at the BoC rates, or the 5-year Canada rates? Should I wait until year end to re-invest my GICs? Should I invest $10k in July, Aug, Sept, Oct, Nov, Dec?

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Post by scomac » 02 May 2007 12:12

The purpose of laddering is to spread your maturities out over a period of time (usually years, rather than months) in order to take the guess work out of forecasting interest rate moves.

In your situation, instead of buying a series of 5 yr. GICs over a period of a few months, an effective ladder would be made up of GICs that mature in 1, 2, 3, 4 and 5 years. When the first GIC in the new ladder matures you simply replace it with a new 5 yr. GIC.
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