The Conventional Wisdom

As the substantial majority of our investors are tax-paying individuals and families, we believe it is our duty to incorporate an after-tax mindset in our bond investment activity. Let's start with some conventional wisdom:

"Concern yourself with making money first - then think about the taxes."

We regard this as excellent advice - for equity investors. Because stocks carry exceptionally wide ranges of asset value, the success of the investment is largely defined by its entry price, not it's tax rate. Fixed income is a different matter however.  Here, different classes of debt carry relatively smaller differences of return. When combined with vastly different tax rates between capital gains and ordinary interest income, it turns out that after-tax returns in fixed income vastly differ often depending on how the returns were produced.

To our delight, we have observed that the market largely does not differentiate between bonds based on their tax characteristics. Naturally, we have been capitalizing on this dynamic for you since the Fund’s inception, more than nine years ago.
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The After-Tax Mindset

The essence of this tax-aware mindset is to favor bonds issued with low interest rates (ie: a low “coupon”). Since market yields change, bond prices also change to reflect a new fair rate of return. This means bonds with very low, below-market coupons tend to be priced at attractive discounts to par. The lower a bond’s coupon, the higher the price discount tends to be. Through this price discount, a bond’s return becomes more valuable. A bond priced at a discount earns its return not only through its coupon, but (importantly) through the gradual appreciation of its price to par maturity. And the greater the price discount, the greater proportion of the bond’s total return will be generated from the bond’s price appreciation. This price appreciation is counted as a capital gain, which conventionally bears a substantially more favorable tax treatment than ordinary interest income. In an asset class that sweats over basis points (one-hundredths of a percent), this is a highly valuable nuance for taxable clients. And while this approach produces no difference to the pre-tax results you see on the facing page of this letter, it has the potential to make a difference to your bank account and in a few other ways which we will share.
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Tax Deferral

Taxes on interest income are paid annually as the income is received, so a traditional, high-coupon bond could logically results in a higher tax bill every year. By contrast, a low-coupon, discounted bond gradually moving to par should incur far less tax until the year of its sale (or its maturity as the bond returns to par), effectively postponing much of the tax impact, better compounding an investment’s value.

Success-Based Taxes

Taxes on capital gains are owed only if the bond is sold at a profit. When the bulk of an investment’s expected return comes from price appreciation, this is advantageous. Capital gains tax is, by definition, contingent on the success of the investment. On the other hand, high-coupon bonds generate taxable interest every year, even if the bond later loses value or - even worse - the company goes bankrupt.

Safer Return Generation

Since higher yields typically mean higher credit risk, we are always seeking more conservative ways to achieve safer after-tax returns. By taking advantage of the tax benefits of discounted, low-coupon bonds, we have historically been able to achieve similar levels of after-tax return of a higher-yield, higher-risk bond, through a lower-risk company based on our opinion of its fundamentals and/or stated credit rating.

Pleasant Surprises

Another benefit comes from company takeovers. Each year, it’s not unusual for four to five percent of public companies to be delisted due to mergers or acquisitions.¹ When this happens, their bonds are very often paid off at par or better. Discounted bonds, in these cases, contain a “hidden bonus” - the chance for an immediate and positive jump in value if such an event occurs. We should add that this value is not theoretical - we experienced two of these events in the portfolio just last year.

Where Flexibility Counts

While this concept is simple, we have taken it very seriously. We have applied this lens as we’ve scoured the market for opportunities. Fortunately, we found an excellent base for tax-advantaged idea generation: the US convertible bond market. These bonds (which must be paid in cash at their maturity unlike their Canadian counterparts) typically bear coupons between zero and two percent and have five-year terms.² This US$300 billion-dollar market trades primarily over equity or equity derivative desks, putting it outside the scope of convenience for many traditional fixed income investors. We also like that, given the number of issuers (~500), in our experience, at any given time there are convertible bond issuers that are amid some adversity or mispricing. We have shared convertible bond case studies to highlight this attractive space in prior communications. In sum, our activity in this fixed income market niche is a perfect example of how we use our flexible mandate to generate quality risk-adjusted returns.

So why doesn’t everyone else focus on low coupon bonds? The reasons are many.

Clients

The investment management industry – fixed income in particular – has very substantial customers in pensions, endowments, and foundations. These entities are often the largest and most popular organizations to service. These entities are tax-exempt, so they do not care about the sources of return. Investment managers who count these entities as large clients (almost any manager of scale) may naturally jettison tax considerations as well.

Marketing

Because of the multi-faceted nature of taxes and varying individual tax rates, it is not particularly easy to communicate results with respect to tax. In addition, since pre-tax returns are the industry standard basis of competition, it should not be a surprise that some managers simply optimize for ‘headline’ (pre-tax) fund returns.

Size

For large asset managers (which most fixed income managers are), capital is always required to be put to work. This often presents a problem, where a manager is very much constrained by what’s available in the market. What is available isn’t always economically convenient. Indeed, there are numerous examples of highly liquid bonds in the market having average (or worse) tax characteristics.

Let's Talk

Tax-aware fixed income investing is rarely discussed, but for taxable investors, the cumulative impact is hard to ignore. And it starts with a conversation - about your goals, your tax picture, and whether your fixed income portfolio actually reflects them. If this perspective resonates with you, we would be happy to discuss it further.

1. Michael J. Mauboussin and Dan Callahan, Birth, Death, and Wealth Creation (Morgan Stanley Investment Management, Counterpoint Global Insights, July 25, 2023)

2. Bloomberg

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