Saturday, February 27, 2010

Fix(ed) Income?

So a GIC is basically a loan from you to the bank or another financial institution for a ‘guaranteed’ interest rate and for a specific period of time or term. Canada Savings bonds would fall in a similar category of lending, now to the Government, and usually for even worse rates.

So what is the difference between a Canada Savings Bond and a Government of Canada Bond? Basically the only difference is that the Government of Canada Bond can be traded and it has terms that range from a few days to ten years or all the way up to 30 years. So how does it work?

Typically, you can buy a government bond from a brokerage who has carved it in slices of $100. The government pays an interest on the principal ($100) and repays this principal (and stops paying interest) at the end of the bond’s term. The bond’s interest rate is often called the ‘coupon rate’

The government has issued or sold to you a $100 bond with a coupon rate of 5% for a 10 year term. So the government pays you (typically every 6 months) interest i.e. 5% x $100/2 = $2.5 or a total of $5.00 per year. The government will do so for the next 10 years and then repay you the $100.

A year later after buying such a bond, interest rates for 9 year term government bonds falls to 4%. You still receive your $5 per year over the nine remaining years, while new bond buyers would only receive $4. So wouldn’t you agree that there may be people who would consider your $100 bond worth more than the new $100 bonds? So they may want to buy your bond. How much should they pay?

High school math. My little Excel Spreadsheet calculates the new value as: 106.62. So at 4% would I still make $45 worth of interest? You pull out your calculator and press 4% x 106.62x9 years=$38.38. Eh? Oh, but my bond value went also up from $100 to 106.62. So I made a capital gain of $6.62 and... $6.62 plus 38.38=$45

Now why would you sell a $100 government bond that pays you $45 interest for one that pays $38.38 in interest plus capital gains of $6.62? Answer, you get the $6.62 right now and... there is more!

Taxes! At Alberta’s top income tax rate of 38%, you pay $17.10 in taxes over $45 interest income.

But if you sold it and reinvested at the new rate (4%), you'd pay ‘only’ 0.38x38.38= 14.59 plus 0.38x0.38/2=1.26 or a total of $ 15.84 in taxes. So on an AFTER tax basis you made $27.90 or 3.1% per year without selling and $29.16 or 3.24% per year with selling. With a yield of 3%, your after tax return would increase to 30.59 or 3.4%. Little things add up.

So yield is the current interest rate plus annual capital appreciation-or-loss divided by the purchase price and equals the coupon rate of a similar bond issued today. The Yield on a Canadian Government Bond for a 5-year term is now only 2% but 100% guaranteed by the Government of Canada. A 10 year bond yields 3.75%

Government of Canada Bonds are more secure than a similar GIC which is only covered by the CDIC for $100,000 per account. Hence a slightly lower yield than the GIC interest rate. Of course, you could not cash in your GIC because it is not tradable like a government bond is. If you invest in Provincial Government bonds, depending on the Provincial credit quality, yields are higher and corporate bonds for the banks, the same ones that you lend your GIC money to, are still higher and may exceed GIC rates.

Due to the ‘extreme large drops’ in short term interest rates from the highs in the middle of the 2008 credit crisis and before to today’s levels many long term bonds generated significant capital gains in addition interest income totalling close to 10% per year. During times of depression and recession, interest rates often fall and bonds can prove to be quite profitable. Also investing during the highly inflationary early 1980s in long term bonds resulted in very high interest income and capital gains during the subsequent 10 to 15 years, in fact all the way until today. 2008 may become a turning point from where we may go into a decade of ever increasing interest rates and bond yields. How much the increases are going to be is a sensitive topic of discussion amongst today’s financial gurus and demographers. If you want a copy of my tiny ‘Bond Evaluator’ Spreadsheet just e-mail me.

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