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Jim Maroney

:: Canadian Savings Bond (CSB) not a good deal if you consider the negative impact of income tax and inflation on real after-tax returns

:: What more can you expect from a 56-year old? If I’m referring to a human being, that’s an insult, but when the point of discussion is a financial product the question becomes fair game. Introduced in the first year after the war (WWII that is), the Canada Savings Bond (CSB) has become as much a part of the fall season as the changing colours and falling leaves.

In between trash talkin’ the Monarchy, Minister of Finance John Manley managed to launch the 2002 – 2003 CSB campaign at the beginning of this month. Regular readers will know that I’m no fan of CSBs but if you’ve had money tied up in the stock market during the past few years, security and the prospect of earning a positive return, no matter how small, has got to be appealing.

As has been the case for the previous five campaigns, the Government of Canada is offering two retail bonds: the original CSB and the Canada Premium Bond (CPB). CSBs and CPBs are similar in that both are fully backed by the Government of Canada. Furthermore, both CSBs and CPBs mature at the end of ten years and both are offered in two forms: regular interest bonds (R-bonds) that pay interest annually and compound interest bonds (C-bonds) that, not surprisingly, reinvest the annual interest earned rather than paying the amount out to the bondholder.

CPBs can only be cashed once a year on the anniversary date of the issue date and up to 30 days thereafter. On the other hand, CSBs can be cashed at any time. This difference in liquidity explains the reason CPBs offer a higher rate of return than CSBs at the time of issue.

The current CPB (Series 27) offers an annual interest rate of 2.50 per cent starting November 1, 2002. The annual CPB interest rate then escalates on each anniversary date as follows: 2003 – 3.0 per cent; 2004 – 4.0 per cent; 2005 – 4.85 per cent and 6.0 per cent in 2006. For holders of R-bonds this works out to an effective annual yield of 4.0 per cent. Holders of C-bonds will achieve a slightly higher yield at 4.06 per cent.

Currently, five-year redeemable Guaranteed Investment Certificates (GICs) rates range from 3.5 per cent to 4.85 per cent so the five-year CPB rate is pretty much middle of the pack. If your intent is to tie your money up for a full five years, a better return can be achieved with non-redeemable GICs where rates range from 3.55 per cent to 5.0 per cent. So if redemption is important, the CPB isn’t a bad choice when compared to redeemable GICs particularly when you consider the lower minimum deposit of CPBs ($300 for R-bonds and $100 for C-bonds) in comparison to GICs where a minimum deposit of $500 or more is required depending on the financial institution.

Turning to the real after-tax return (i.e., the only return that counts) of the current CPB offering, you need to consider how much of the 4.06 per cent return on the current CPB is lost to income tax and inflation. If you assume a top tax rate of 43.7 per cent and an inflation rate of 2 per cent, the real after-tax return on a CPB for a BC taxpayer at the highest marginal tax rate is only 0.29 per cent. For a BC taxpayer taxed at the lowest rate (i.e., taxable income below roughly $31,000) this real after-tax return increases to 1.17 per cent. To summarize, at all tax brackets a CPB will allow an investor to retain purchasing power while offering only a marginal real return.

The same cannot be said for CSBs where the rate of return is a paltry 2.0 per cent for the first year. Granted this rate is the minimum guaranteed rate and it may be increased if market conditions warrant but investors don’t even need to power-up their calculators to figure out that the real after-tax return on a 2.0 per cent CSB is negative. The lower rate in comparison to CPBs is the price investors pay for the “cashable at any time” feature of CSBs – a rather heavy price to pay in my mind.

If you can withstand locking your money up for 60-days or more and you have at least $5,000 to invest you can earn a return of 2.85 per cent on a non-redeemable, fixed-term GIC. While this still isn’t a high enough rate to achieve a positive return after accounting for tax and inflation, it’s certainly better than the 2.0 per cent CSB offering.

In conclusion, if you have a bit of money to invest and you don’t mind locking in for a longer term, GICs can provide a better return than either CPBs or CSBs. If security and the ability to redeem your investment is important and an annual redemption feature is good enough, then CPBs aren’t a bad deal. Where CSBs are at issue, investors should look elsewhere.

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Free Tax Advice Article Submitted to Income Tax Canada.net exclusively by Jim Maroney
CA Canadian Chartered Accountant with Brown, Andrews & Maroney in Maple Ridge, BC, Canada

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