Buy bonds and pay less tax

When it comes to conservative investing, investors typically head towards fixed income over equities. Historically, bonds have demonstrated significantly lower risk qualities than equities. While safety is better, fixed-income investments have two significant knocks against them. First, they typically provide lower returns. Today interest rates are at significant lows, which has a severe negative impact on investors’ returns. The second knock is fixed-income investments do not have tax efficiency of investment income. Equities get the edge because they provide investment income in the form of dividends and capital gains, both of which give tax-preferred benefits to the investor. Fixed-income investments, unfortunately, report all income in the form of interest, which is fully taxable.

Corporate class fixed income

However, there are a few fixed-income mutual funds that are truly innovative from the standpoint that they offer investors the security of fixed-income investing with the tax benefits of equities. Here, we find the corporate class, fixed income mutual fund.

Today, there are only 11 funds that fit the mold of corporate class, fixed-income investments:

  • Bissett Bond Tax Class A
  • Synergy Canadian Short-Term Income Class
  • BMO Short-Term Income Class
  • Synergy Global Short-Term Income Class
  • CI Canadian Bond Sector
  • CI Global Bond Sector
  • CI Signature Corporate Bond Sector
  • Investors Managed Yield Class B
  • Middlefield Short-Term Income Class
  • MIX Structured Bond Class
  • AIC Total Yield Corporate Class

A look at performance

One of the difficulties with analyzing these 11 investments are they do not have a long track record. Only 4 of the 11 funds have a 3-year track record and only one of those funds, the Synergy Canadian Short-Term Income Class, has a 5-year track record.

When you look at the performance of these funds over a 1, 2 and 3-year period, the returns are not exciting like income trusts or equities. However, when you consider these are bond investments, they are providing very reasonable returns on a relative basis.

After tax is what counts

Let’s first assume a 35% marginal tax rate. Second, let’s assume this is non-RRSP money. Given these two assumptions, the goal is simple-it is not about what you make but rather what you keep after paying taxes that counts.

Here are some important observations on these 11 funds:

Observation #1 – Corporate class bonds have had no distributions. Unlike trust-structured mutual funds, corporate class funds do not have to issue distributions and even when they do, they can issue them in the form of capital gains and dividends instead of interest. According to Morningstar, Paltrak, all of the corporate class bond funds have had zero distributions and therefore have 100% pre-liquidation tax efficiency.

Observation #2 – So far, observation one allows investors to defer taxation of investment income into the future when the investment is actually liquidated. It can be switched into alternative equity-based investments with no disposition.

However, once the funds leave the corporate structure, the investor has to pay tax. At this point there is another benefit to the investor because the gains are now taxed as capital gains and not interest income. As a result, there is less tax and more profits in the pocket of the investor. As an example, the Bissett Bond

Tax Class A has a 3-year gross return of 5.9%. But given the assumptions, the investor would have kept 4.87% after tax. With the average bond fund (trust), the pre-tax, 3-year return was 5.3% and the after-tax return was 3.7%. In fact, an investor only has to earn 4.7% pre-tax in a corporate class bond fund to equal a 5.3% return in a regular bond fund.

Observation #3 – MERs make a difference with bonds. Many corporate class funds are often criticized for having high MERs. MERs have a higher impact on fixed-income investments than they do on equity investments. I must admit that I was pleasantly surprised to see 2 funds with lower MERs than the average Canadian bond fund. Both the Bissett Bond Tax Class A and the Manulife MIX Structured Bond funds have MERs that are 1.44% and 1.42% respectively. Compare that to the average Canadian bond fund with an MER of 1.98% and you have some good news for investors. Take all the tax benefits, a lower MER and some solid management and you’ve got a great alternative for fixed-income investors looking to invest non-RRSP dollars.

My two cents

In the past, I have often suggested that investors hold their fixed-income allocation inside the RRSP for maximum tax efficiency. Now, with the innovation of corporate class bond funds, there is a solution for all those conservative investors wanting to hold bonds outside the RRSP. If you need fixed income outside the RRSP, consider these corporate class mutual funds for a solution.

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