How high-yield bonds can sink your profits

Much of southern Ontario is suffering from a drought this summer, which has impacted gardeners and farmers alike.

The bond market is also caught in a drought—at least as far as yields are concerned. But you should think twice before wishing to return to a high yield era. Not only do bond prices fall when yields rise but, when yields are high, taxes and inflation can turn profits into losses in the blink of an eye.

To explore the issue I’m going to focus on the returns generated by one-year U.S. treasury bills, held to maturity, during two different periods. I’ll stick with a 50% tax rate for simplicity’s sake.

In 2015, one-year U.S. treasury bills generated paltry returns of 0.25%. The small gains didn’t keep up with inflation (U.S. CPI) which boosted prices by 0.73% over the same period. As a result, the treasury bills generated inflation-adjusted losses of 0.48% before taxes and losses of 0.60% on an after tax basis.

(As an aside for the detail-oriented, the after-tax after-inflation return is calculated by starting with the nominal return of 0.250% which falls to 0.125% after accounting for the 50% tax. The 0.125% gain grows each dollar invested to $1.00125 over the 12-month period. But a dollar’s worth of goods at the start of the year would cost $1.0073 by the end of the year due to inflation. The real return is then found by dividing $1.00125 by $1.0073 and subtracting 1, which equals -0.0060. That’s equal to -0.60% when expressed in percentage terms.)

While losses are always painful, the situation was far worse in 1980 when yields were high. During the year the treasury bills returned 11.70% but inflation was a hefty 12.52%. As a result, investors suffered a loss of 0.73% in 1980 after accounting for inflation. Even worse, they lost a whopping 5.93% after adjusting for both taxes and inflation. The tax slashed the nominal returns in half and then inflation hit hard.

The unfavourable tax on bonds (and bills in this case) is a big reason why investors like to put them in tax-advantaged accounts. Unfortunately, many people have a limited amount of room in such accounts, which can lead to some difficult asset-allocation trade-offs.

It is important to be aware that a big jump in interest rates could be quite painful for bond investors due to a combination of falling bond prices, inflation, and taxes.

Safer Canadian Dogs

Investors following the Dogs of the Dow strategy want to buy the 10 highest yielding stocks in the Dow Jones Industrial Average (DJIA), hold them for a year, and then move into the new list of top yielders.

The Dogs of the TSX works the same way but swaps the DJIA for the S&P/TSX 60, which contains 60 of the largest stocks in Canada.

My safer variant of the Dogs of the TSX tracks the 10 stocks in the index with the highest dividend yields provided they also pass a series of safety tests, such as having positive earnings. The idea is to weed out companies that might cut their dividends in the near term. Just be warned, it’s a task that’s easier said than done.

Here’s the updated Safer Dogs of the TSX, representing the top yielders as of August 8. The list is a good starting point for those who want to put some money to work this week. Just keep in mind, the idea is to hold the stocks for at least a year after purchase – barring some calamity.

Source: Bloomberg, August 8, 2016

Notes

Price: Closing price per share

P/B: Price to Book Value Ratio

P/E: Price to Earnings Ratio

Earnings Yield: Earnings divided by Price, expressed as a percentage

Dividend Yield: Expected-Annual-Dividend divided by Price, expressed as a percentage

As always, do your due diligence before buying any stock, including those featured here. Make sure its situation hasn’t changed in some important way, read the latest press releases and regulatory filings and take special care with stocks that trade infrequently. Remember, stocks can be risky. So, be careful out there. (Norm may own shares of some, or all, of the stocks mentioned here.)