Wednesday, March 11, 2009

Premium Bonds

While longer term high coupon government bonds are now trading at a significant premium, they can still be a worthwhile buy in certain cases. Suppose you need income for the next 14 years, but at the end of that period you will begin to receive a pension, Social Security, etc. If you were to buy a $100,000 face value of an 8 per cent Government of Canada issue, now trading for around 150, you would be locking in a capital loss of 33 per cent in 14 years, not counting the effects of inflation. But in the meantime you would be receiving $108,ooo of income spread over the 14 years. Then, if your pension becomes payable in 2023, the income from it would, we hope, make up for the loss of bond interest.

A further wrinkle with premium bonds is that, in US taxable accounts, the premium can be amortized and written off each year, thus reducing the taxable income. In the example cited above, the amortization would amount to about $3500 per year, so the taxable income would be only about $4500. Unfortunatly the CCRA does not allow this practice, which means that for Canadian investors the capital loss must be taken when the bond is sold or redeemed. Unless there are capital gains to offset it, the loss may be carried back for three years or forward indefinitely. In addition, for Canadian taxable accounts the full amount of the coupon is taxable income each year.

US investors buying Government of Canada bonds may wish to hedge the foreign exchange risk, although the current exchange rate is quite favorable. Similar calculations as those above would apply to long term US Treasuries, but because the US fiscal position is worse than that of Canada at present the long Treasuries may be more risky.

While opportunities for trading gains in long government bonds look very limited now, a buy and hold strategy could work in certain cases.