Wealth Strategies: The Tax Advantages of Buying Bonds at a Discount Versus Buying GICs

Investing in bonds is sometimes thought of as simple, but there are actually various investing techniques to employ. A bond is a debt instrument – an investor is lending money to an institution and receiving interest income in return. That interest income is typically fully taxed at one’s income tax bracket, but there is a way to make your return on a bond more tax efficient.

Bonds are initially issued at a price of $100 called 'par'. However, after issuance, a bond may trade higher or lower than that initial par value. Many bonds are currently trading at a discount due to interest rates rising over the past two years.

Bonds purchased at a discount to par present an interesting opportunity, as they have both an income component and a more favorably taxed capital gains component. The difference between the discounted price at which one purchases the bond and the maturity value (at par) is taxed at an investor’s capital gains inclusion tax rate. Only the coupon interest is taxed at the investor’s full marginal tax rate, and this can lead to meaningfully different after-tax yields at comparable levels.

PROs:

• Higher after-tax yields
• Liquidity
• Potential for capital gains before maturity in downward trending interest rate environment or as bond pulls to par.

CONs:

• No CDIC or CUDIC insurance: Your investment is secured only against the issuer’s credit without any government backstop. This risk is minimized if you stick to high quality issuers.
• Price changes in your investment account: Bond prices are constantly changing, and the price of the bond can further decline. However, in the long run, this can also be a pro as the price can go also go up as the time to maturity gets closer.

Here’s an example using a 50% income tax rate and a reinvestment rate equal to the purchase yield-to-maturity (YTM):

CIBC 1.1% 01/19/26

Ratings: AAL DBRS / A- S&P / AA- Fitch / A2 MOODYS

Rank: Senior Unsecured

Term: Approximately 3-year

Outstanding: $1.25 billion

The bonds are currently trading around $89.95 / 4.87% YTM.

If held to maturity, this bond will have approximately $10 in capital gains (Face Value of $100 - Current Purchase Price of $89.95 = $10.05) amortized over 3 years – taxed at 25% (50% of Marginal Tax Rate of 50%= 50%*50%= 25%).

The rest of the yield comes from the 1.1% coupon (paid semi-annually) – taxed at 50% (Full Marginal Tax Rate).

After tax yield = 3.393%

Using 50%, you would need a GIC pre-tax equivalent yield of 6.79% to get the same after-tax yield. There is more risk with the bond, however, with thorough credit analysis and due diligence, one can enhance yield within an acceptable amount of risk.  

As always, we encourage you to consult with a qualified and trusted wealth management professional for a full picture of these potential benefits and downsides while adhering to one's risk tolerance and capacity.