Hemisphere Capital Management Inc.

Discount Bonds: The Price and Interest Rate Teeter-Totter

One question we get asked is, “Why is the coupon on this bond so low compared to the current interest rate environment?” This is typically due to bonds being purchased at a discount. Discount bonds offer similar returns to other bonds but with potential tax advantages.

What are Discount Bonds?

Discount bonds are debt instruments that are sold below their face value (i.e. at a price less than the amount that will be paid back at maturity). In essence, investors buy these bonds for less than $100 and plan to receive the full $100 (called the principal) at maturity. In addition to receiving the full $100 at maturity, the investor will also receive any coupon payments. The return is therefore made up of two parts – the interest from the coupon payments and the gain/loss from the difference between the purchase price and the price at maturity.

The yield to maturity (YTM) is the annualized return if a bond is held to maturity, with all interest payments reinvested at the same rate as the YTM. This rate is often referred to as the “yield” and is typically used when comparing bonds.

What Causes Discount Bonds to Exist?

Several factors can lead to bonds being sold at a discount:

Market Interest Rates: When interest rates rise – as they have post-pandemic – existing bonds with lower coupon rates become less valuable. This is because, in theory, you should be able to buy a similar bond but now with a higher coupon rate. As a result, the price of existing bonds fall, leading to discounts. If interest rates fall, the opposite is also true with existing bonds becoming more valuable. We liken this to a teeter-totter. As interest rates rise (fall), prices of fixed-coupon bonds tend to fall (rise). Bonds with maturity dates further into the future are typically more sensitive to changes in interest rates so the price tends to react a greater amount.


Credit Quality Concerns: When purchasing a bond, investors are subject to counterparty risk. This is the risk that the bond issuer may default on its obligations and not be able to pay interest and/or repay the principal at maturity. Bonds issued by companies facing more financial and/or operational challenges can trade at discounts due to perceived higher risk.

Bond Example

The below table shows two Canadian National Railway (CNR) bonds. Both of these bonds have a maturity date in 2029 but Bond 2 has a higher coupon (4.6% vs 3.0%). Bond 1 is said to be at a discount (price of $95.67 is less than $100) and Bond 2 is said to be at a premium (price of $102.30 is more than $100). If you were to look only at the coupon, Bond 2 would be more appealing. But since you are paying more for this bond ($102.30 vs $95.67), the yield for the two bonds is very similar.  To calculate the yield, we can use the YIELD function in Excel.

 

BOND 1

BOND 2

Issuer

CANADIAN NAT’L RAILWAY

CANADIAN NAT’L RAILWAY

Interest Coupon

3.00%

4.60%

Maturity Date

February 8, 2029

May 2, 2029

Price

$95.67

$102.30

Yield

4.04%

4.07%

In the case of Bond 1, an investor will receive a smaller coupon (less interest) but will also have a gain of $4.33 ($100 – $95.67) at maturity. This results in the bond yield being higher than the coupon. In the case of Bond 2, an investor will receive a larger coupon (more interest) but will also have a loss of $2.30 ($100 – $102.30) at maturity since the bond was purchased at a premium. This results in the bond yield being lower than the coupon.

As expected, since it is the same issuer (same counterparty risk) and the bonds have fairly close maturity dates, they have a similar yield – even with the different coupons. In effect, the price of the bond adjusts for the difference in the coupons so the overall return is similar.

What are the Tax Benefits of Owning Discount Bonds?

Discount bonds can offer certain tax advantages. This is because a portion of the return is a capital gain as opposed to interest income. Interest income is taxable as regular income at the investor’s marginal tax rate. Capital gains are typically taxed at a lower rate, providing potential tax savings.

Investors holding bonds within registered accounts, such as Tax-Free Savings Accounts (TFSA) or Registered Retirement Savings Plans (RRSP), can eliminate or defer tax on the interest income and capital gains.

How Does Hemisphere’s Bond Strategy Take This into Account?

Our Calgary wealth managers are always looking to minimize tax as we implement our wealth management strategies. For all of our service offerings, we tend to own individual bonds rather than owning bond funds or ETFs. This gives us better control over where to position our bond holdings to minimize the tax impacts. By owning higher coupon bonds in registered accounts and lower coupon (discount) bonds in taxable accounts, we can minimize a client’s tax liability from owning bonds.

If we look at our example above, Bond 1 would be well suited for a taxable account since the tax benefits from the lower interest income will likely offset the slightly lower yield. Bond 2 is well suited for a registered account since the tax impacts are less relevant and Bond 2 has a higher yield.

To effectively integrate bonds into an investment and wealth management strategy in Calgary, it is crucial to understand the relationship between interest rates and bonds. Understanding the potential tax implications of bond ownership is also important. To learn more about bonds and how we can help you with your wealth management strategy, speak to one of our financial advisors in Calgary.

The content in this article is provided for the benefit of our clients based on information we believe to be accurate and complete. Although every effort has been made to ensure its correctness, the ultimate accuracy cannot be guaranteed. This does not constitute tax or legal advice. Hemisphere Capital Management Inc. is not a professional tax services firm. Readers should consult a qualified professional prior to implementing a strategy. Interest rates, market conditions, tax rules and other factors are subject to change. This information is not investment advice and should only be used in conjunction with a discussion with your financial advisor.