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

Author

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  • Landon, Stuart
  • Smith, Constance

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.

Suggested Citation

  • Landon, Stuart & Smith, Constance, 2008. "Taxation and bond market investment strategies: Evidence from the market for Government of Canada bonds," MPRA Paper 9959, University Library of Munich, Germany.
  • Handle: RePEc:pra:mprapa:9959
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    File URL: https://mpra.ub.uni-muenchen.de/9959/1/MPRA_paper_9959.pdf
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    References listed on IDEAS

    as
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    More about this item

    Keywords

    taxation; bonds; after tax returns;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • H24 - Public Economics - - Taxation, Subsidies, and Revenue - - - Personal Income and Other Nonbusiness Taxes and Subsidies

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