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- When seeking the highest
return on your bond portfolio

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and considering bond yields
currently at all time lows,

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the highest income or bond yield

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isn't necessarily the best solution

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for a taxable investor.

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Here to discuss just that,

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I'm joined by Heather Mason-Wood,

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Chief Strategy and Operating Officer,

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as well as Portfolio Manager
at Canso Investment Counsel.

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Heather, it's great to have you.

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- Thank you, Jen.

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I'm very happy to be here.

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- So why don't we jump right in

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What are the main concerns
a taxable invesetor faces

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in this low rate environment?

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- Sure, the first thing a bond investor

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has to think about is what they're paying.

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What's the price they're paying
for the bond they're buying.

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Now bonds are issued at a hundred dollars

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which is called par

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but they trade in the market after that.

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And the price moves based on
a number of different factors.

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But one important factor is
prevailing interest rates.

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So if interest rates go up, the
price of the bond goes down.

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If interest rates go down,
the price of the bond goes up.

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I know that's totally counterintuitive.

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It doesn't, it's not,
it doesn't make sense

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without really thinking it
through, but here's how it works.

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So let's suppose you have two bonds

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from the same company and
they have the same maturity.

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One pays you $5 a year in interest.

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One pays you $1 a year in interest.

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Would you pay the same
amount for the two bonds?

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No, you wouldn't.

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You'd pay more

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for the bond that gives
you higher cash flows.

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So many investors would
choose the higher coupon bond

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and think this is great.

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Now that's fine if they're not taxable,

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but for a taxable investor

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that's not necessarily the right choice.

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Let's look at an example to
make it easier to follow.

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We've all heard about Boeing Inc.

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Boeing is an aircraft manufacturer.

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They issue a lot of bonds

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because that's how they fund

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their capital expenditure programme.

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And so I found two bonds with
almost the same maturity date

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both mature in March, 2039.

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So about 18 years from now.

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The one that matures on March 1st

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has a three and a 1/2 percent coupon.

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The one that matures on March 15th,

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has a six and seven, 8% coupon.

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So let's see where
those bonds are trading.

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The one with the lower coupon

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is trading just below par right now, $99.

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The one with the higher
coupon is trading at $140.

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So now let's see what the
taxes are for these two bonds.

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So interest income is taxed

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at the highest rate, which is 53%.

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So if you get $3 and 50 cents in interest

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then you're gonna pay a dollar 86 in tax.

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If you're getting $6.88

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then you're gonna pay $3.65.

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So what does that mean over the 18 years?

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While your tax bill on the lower coupon

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one is just under 33.50.

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The higher coupon bond
is 65.70, almost $66.

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So that's not necessarily the
bond that you wanna choose

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the higher coupon one.

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Now some people would say,

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well, yes but I have a capital loss

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because I pay 140 and then
I get a hundred at maturity

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and I can use that against capital gains.

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Well, that's true.

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But capital gains are only
taxed at 1/2 the rate of income.

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So that capital loss
only saved you about $10.

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So really your better choice

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for a taxable investor
is the lower coupon bond.

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- And Heather, how do preferred shares fit

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into an income portfolio
for a taxable investor?

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- Well, that's a good question.

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Preferred shares are often
used in fixed income portfolios

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because like bonds,
they have a set coupon.

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So they do produce income
on a very regular basis.

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Now preferred shares...

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The benefit of preferred
shares is dividends

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are taxed at a lower rate than interest.

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So that's why a taxable investor

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might prefer preferred shares.

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The issue with preferred shares

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is you do have to really
consider credit quality

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you do with bonds

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but with preferred shares
you can end up with zero

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if the company experiences
financial difficulties.

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So that is a very key consideration.

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But let's have a look at
a Royal Bank of Canada

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preferred share and look at the tax impact

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versus holding a bond
with the same coupon.

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So the Royal Bank preferred
share has a 4.8% coupon.

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So that's of course attractive
in this environment.

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So if you have $4.80 of dividends,

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the dividend tax rate is only 39%.

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Remember it's 53% for interest income.

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So if you're paying that, then your tax

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is about a $1.87 on $4.80 of dividend.

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If you have $4.80 of interest

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you're gonna pay $2.54 in tax.

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So there is a benefit to
having a preferred share

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versus a bond with the same coupon.

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Preferred shares are like bonds

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in that they trade in the market.

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They are impacted by interest
rates in the same way,

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because their coupon is fixed.

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There are some floating rate,
but generally they're fixed

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and they, so they all go up in price

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if interest rates go down

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and they'll go down if
interest rates go up.

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So there's a number of factors

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that have to be considered
when adding preferred shares

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to a fixed income portfolio.

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- And what factors does Canso consider

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when structuring tax efficient portfolios?

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- Well, the first thing
Canso looks at for any client

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whether they're taxable or
not is the credit quality.

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So that's always the first consideration

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because you should never have tax drive

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your investment strategy.

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The first thing should
be a quality risk return.

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Then for our taxable investors,

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we look at okay if we
like a particular issuer

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which of their issues make the most sense

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to hold in this portfolio?

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Do they have discount bonds?

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Which would be a lower coupon bond.

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Do they have lower
coupon preferred shares?

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Where are these trading

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in the market versus a
sort of normal value?

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Because there's times when bonds

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and preferred shares fall out
of favour, the price goes down

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and that might be the right
time to be buying them.

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So we definitely look at
what is the after-tax impact

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of any investment we add to
a taxable investor portfolio.

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- Well, thank you for for your time, Heather,

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to read more on investing
in this low rate environment

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and Canso's view on the markets,

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read the January Market Observer

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available on the Canso Funds website.

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- Thank you, Jen.

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It was a pleasure to be here.

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