Taxation and bond market investment strategies: Evidence from the market for Government of Canada bonds

• Author(s) / Creator(s)

  • Landon, Stuart
  • Smith, Constance E.

• This article shows that, contrary to the suggestion of some investment advisers, for an individual Canadian investor subject to personal income taxation, the after-tax yield on a discount bond is always higher than (or, at worst, equal to) the yield on a premium bond. This follows because the tax rate on capital gains is lower than the tax rate on coupon income in Canada. It is also shown that a decline in the capital gains tax rate raises the after-tax yield on discount bonds but reduces the after-tax yield on premium bonds, and may even cause the yield on premium bonds to become negative. Further, a cut in the tax rate on interest income raises the after-tax yield on all bonds, but raises the yield on premium bonds relative to discount bonds. While the lower after-tax yields on highercoupon bonds might be expected to cause the pre-tax yields on these bonds to rise, no evidence of such tax capitalization is found using a large data set of matched pairs of government of Canada bonds for the period 1986-2006. The observed near-equality of pre-tax yields since 1995 for bonds with different coupons implies that individuals in Canada earn a significantly smaller after-tax yield from holding premium bonds than discount bonds.

• Date created

  2008-01-01

• Subjects / Keywords

  • Discount
  • Taxation
  • Bonds
  • Investment Income
  • Capital Gains
  • Personal Income Taxes

• Type of Item

  Article (Published)

• DOI

  https://doi.org/10.7939/R3W08WZ84

• License

  Attribution-NonCommercial 4.0 International