Reader alert: This is part 2 of a five-part series.
• Part 1: Tackling tax-efficient investing
• Part 2: Capital gains mean tax-efficient investing
• Part 3: Tax-efficient investing and dividends
• Part 4: Magic of tax-efficient bond investing
• Part 5: Tax-efficient investor behaviour
A well-diversified portfolio should include bonds as well as stocks. From an investment perspective, bonds have several desirable characteristics. Subject to the issuer remaining solvent, they:
• Pay known amounts of interest at known, regular intervals.
• Have a known maturity date at which they have a known value, i.e. their nominal value.
Compare this with the characteristics of stocks. Dividends from stocks are at the discretion of the company’s board of directors. Also, stocks never mature, and there is no date on which their future value is known with certainty. Furthermore, in the event of the issuer’s bankruptcy, bondholders are paid in priority to stockholders.
Because the characteristics of bonds are different from those of stocks, the returns of the two asset classes tend to be uncorrelated. Consequently, the inclusion of bonds in a portfolio improves its diversification. Unfortunately, bonds are not very efficient from a tax perspective. The return on bonds largely takes the form of interest, which is fully taxable — unlike capital gains, only 50% of which are taxable.
The importance of asset location
The quandary, then, is how to gain exposure to bonds and benefit from their desirable investment characteristics, while at the same time avoiding the unfavourable tax treatment of interest income.
A widely used solution is to hold investments in the appropriate type of account, depending on the nature of their returns and the way the returns are taxed. This is known as asset location — not to be confused with asset allocation, which is concerned with dividing the portfolio into asset classes such as stocks, bonds and cash.
Broadly, the choice exists between taxable and tax-advantaged accounts. Tax-advantaged accounts include:
- Non-taxable accounts, such as Tax-Free Savings Accounts
- Tax-deferred accounts, such as RRSPs, Registered Education Savings Plans (RESPs) and Registered Disability Savings Plans (RDSPs).
Bonds would be held in tax-advantaged accounts, where the interest would be sheltered from tax. Stocks, on the other hand, would be held in taxable accounts, where they would attract less tax than bonds because, in general, a large portion of their return takes the form of capital gains.
Thus, tax-efficient investing involves not only the choice of the right type of investment — based on the investor’s investment objectives and risk tolerance — but also choosing the right place to hold each type of investment. As with asset allocation, decisions on asset location should be based on expected long-term returns. Changing the location of assets in response to short-term conditions would probably be counterproductive because it would generate unnecessary trading costs and taxes.
Mind the attribution rule
The attribution rule is another reason why you may want to advise your clients to hold bonds within a tax-advantaged account. Many parents transfer money to their minor children in order to pay for their university education down the road. The most tax-efficient way to do this is within an RESP. There is no tax on the returns as long as the money stays within the RESP. When the money is ultimately withdrawn, the returns are taxed in the hands of the child. Furthermore, the attribution rule does not apply to income earned within an RESP.
If money is transferred to a minor child and invested outside an RESP, any interest earned on the investments is attributed back to the parent and taxed in his or her hands. However, capital gains are not attributed back to the parent; instead, they are taxed in the hands of the child. This is beneficial because the child probably pays tax at a lower marginal rate than the parent, if at all.
Note that dividends are also attributed back to the parent. This suggests that when a parent transfers money to a child, the portion to be invested in bonds and dividend-paying stocks should preferably be held within an RESP, whereas non-dividend-paying stocks should be held within a taxable account.
An intriguing way to gain tax-advantaged bond exposure would be to invest in mutual funds generating interest-like returns that may be taxed as capital gains. The return of these funds is linked to that of a bond index or, alternatively, to that of an actively managed bond fund — this provides the investment exposure. At the same time, the funds claim the return takes the form of a capital gain — only 50% of which is taxable — rather than interest.
This feat of financial alchemy is achieved through the use of a derivative known as a forward contract. When we purchase an asset, whether it is a consumer good, a tangible investment or a financial instrument, we normally take immediate possession of it. A forward contract is different because it provides that the asset will be delivered at some future time.
The asset to be delivered can be almost anything — a stock or bond portfolio, a commodity. The price to be paid for the asset is agreed upon in advance by the parties involved. They can agree either on a fixed price or on a method for calculating the price. For instance, the price can be based on the return of a bond fund, known as the underlying asset. The financial alchemy is possible because, provided certain conditions are met, the profit from a forward contract may be taxed as a capital gain rather than as income.
The mechanics are as follows: The fund buys a portfolio of stocks. At the same time, it enters into a forward contract with a counterparty, under which it undertakes to deliver the stock portfolio to the counterparty at some future time. The contents of the portfolio are agreed upon in advance by the parties. The price the mutual fund receives for the stock portfolio is determined by reference to the return of an underlying bond fund.
The fund’s profit is equal to the difference between the selling price and the cost of the stock portfolio. Since the selling price is determined by reference to the return of an underlying bond fund, the profit is equal to the return of the bond fund. For tax purposes, the profit may be treated as a capital gain, provided certain conditions are met – see the example below.
Example: Bond fund magic
The ABC Managed Yield Fund invests $100,000 in a stock portfolio. It enters into a forward contract under which it undertakes to deliver the stock portfolio to the counterparty in a year’s time. The selling price for the stock portfolio will be equal to its cost plus the return of the ABC Bond Fund, an actively managed bond fund.
In order to hedge its exposure, the counterparty invests $100,000 in units of the ABC Bond Fund. When the forward contract matures in a year’s time, the units are worth $110,000, which implies a return of 10% for the ABC Bond Fund. The counterparty redeems the units and pays the proceeds to the ABC Managed Yield Fund in consideration for the latter’s stock portfolio.
The ABC Managed Yield Fund now has $110,000 in cash and its return for the year is 10%, which is equal to the return of the ABC Bond Fund, less fees and expenses, including the cost of the forward contract. The return takes the form of a profit on the settlement of the forward contract, which may be taxed as a capital gain, provided the required conditions are met.
When we look through the veil of the legal agreements, the economic reality is this: Although it holds a stock portfolio, the ABC Managed Yield Fund is actually exposed to the underlying bond fund and its return is equal to that of the fund, less fees and expenses. However, the return does not take the form of interest but of a gain on the settlement of a forward contract, which may be taxed more favourably.
The counterparty holds units of a bond fund but is actually exposed to a stock portfolio, the contents of which it will have agreed upon beforehand with the ABC Managed Yield Fund. The counterparty is exposed to equity risk but its balance sheet shows an investment in a comparatively conservative bond fund. If the counterparty is a regulated entity required to hold a minimum amount of risk-adjusted capital, it may be able to demonstrate a higher level of risk-adjusted capital than if it had held the same amount of equities on its balance sheet.
What are the risks?
Bear in mind mutual funds such as the ABC Managed Yield Fund do not usually have an advance ruling from the CRA to confirm that this tax treatment will apply. In the “Risks” section, the simplified prospectus of the funds invariably contains a warning that the actual tax treatment could be different from that described. This would happen if the tax authorities decide to treat the fund’s profit from the forward contract as income rather than as a capital gain. Buyer, beware.
Also bear in mind that there are costs associated with forward contracts. All else being equal, the return of the fund will be lower than the return on the underlying bond fund by the cost of the forward contracts. Finally, the fund is subject to counterparty risk. If the counterparty goes bankrupt prior to the maturity of the forward contract, the fund will not be able to collect the sale proceeds and its return will not mirror that of the underlying bond fund.