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

Stuart Landon () and Constance Smith

MPRA Paper from University Library of Munich, Germany

Abstract: This paper shows that, contrary to the suggestion of some investment advisors, for an individual Canadian investor subject to personal income taxation, the after-tax yield on a discount bond is always higher (or, at worse, 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 higher coupon 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 dataset 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.

Keywords: taxation; bonds; after tax returns (search for similar items in EconPapers)
JEL-codes: G12 H24 (search for similar items in EconPapers)
Date: 2008-05
New Economics Papers: this item is included in nep-fmk
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