The Strip, the GIC, and the Callable
Marguerite is 64, retiring in two years, with $1.2 million in a non-registered account. Her combined marginal tax rate is 45% on interest and 24% on capital gains. She will need about $30,000 a year of portfolio cash flow after retirement and wants no more than 30% equity exposure. She is allocating $200,000 of a five-year ladder and is choosing among three options:
(a) a provincial strip bond maturing in exactly five years, yielding 4.35%, quoted at 80.83; (b) a five-year non-redeemable GIC at 4.10%, interest paid annually; (c) a corporate bond with a 5.90% coupon, priced at 101.50, five-year maturity, callable at par any time after 12 months.
Marguerite believes the Bank of Canada will cut rates by 150 basis points over the next 18 months and wants to lock in yield. Her advisor has suggested that she simply choose whichever option carries the highest quoted yield.
1. Compare options (a) and (b) on an after-tax basis and identify the non-tax factors that decide the choice.
Read the worked answer
The quoted yields are not comparable per dollar, and the tax treatment decides it.
The strip at 80.83 costs $161,660 for $200,000 of par - or $247,400 of par for a $200,000 investment. The yield is 4.35%, but the discount accrues as interest and is taxed annually at 45% even though no cash arrives. Tax of roughly $3,200 to $3,800 a year, rising to about $3,750 in the final year, must be paid from other funds. After-tax return is about 4.35% x (1 - 0.45) = 2.39%.
The GIC earns 4.10% x (1 - 0.45) = 2.26% after tax, with cash delivered annually.
The strip wins on paper by about 13 basis points a year. It loses on the practicalities: Marguerite needs $30,000 of annual cash flow from age 66, and the strip produces none for five years. The position is illiquid and would be sold at a bid-ask spread if she needs money. And she must fund roughly $3,500 of tax each year from elsewhere, which erodes the advantage.
If the tax can be paid from other income, the strip is marginally better. If she wants the coupon cash for spending, the GIC is the better instrument despite the lower quoted yield. Splitting the allocation is a reasonable compromise.
2. What is the yield to call on option (c), and why is the quoted 5.90% coupon misleading given her rate view?
Read the worked answer
The 5.90% coupon is not the return. At 101.50 the bond is bought at a 1.5-point premium and is callable at par after 12 months.
Yield to call, assuming a call in one year: coupon of $5.90 plus a $1.50 capital loss = $4.40 on $101.50, about 4.33%. Yield to maturity if it is never called is roughly 5.56%.
With rates expected to fall 150 basis points, the issuer will almost certainly call and refinance cheaper. Marguerite would earn about 4.33% for one year and then face reinvestment at rates 150 basis points lower - precisely the outcome she is trying to avoid. She has also paid $1.50 per $100 for the privilege of granting the issuer that option.
The rule: when you expect yields to fall, buy non-callable paper or extend duration; do not buy callable paper at a premium. The call option always belongs to the issuer and is exercised against the holder.
If she wants corporate yield, look for non-callable five-year paper, or a callable priced at or below par where a call does not impose a capital loss. Compare the after-tax yield to the provincial strip as well - a spread of roughly 120 basis points may or may not compensate for credit and call risk, and here it does not.
3. Recommend a structure for the $200,000 and justify it.
Read the worked answer
Separate the cash-flow objective from the rate view, because they point in different directions.
For the $30,000 income requirement, keep a GIC ladder of at least $150,000, with one rung maturing each year and each GIC non-redeemable. If she wants to act on her rate view, extend one rung to five years and lock in 4.10% non-redeemable and non-callable, rather than reaching for a callable bond.
For the remainder, a provincial strip or a five-year provincial bond held to maturity captures the 13-basis-point advantage and the extra liquidity, provided the annual tax bill can be paid from the GIC interest.
Do not buy the callable corporate. Her rate view is exactly the scenario in which she loses the yield she is quoted.
Document the comparison on an after-tax basis, note the strip's zero cash flow and the tax funding source, and record that the 4.33% yield to call was explained and declined. Confirm the GIC's terms in writing: non-redeemable, interest paid annually. If more than $100,000 is placed with a single institution, split it across issuers to stay within deposit insurance limits, since coverage is per insured category per institution.