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Compounding Bonds

Compounding bonds are known by a number of different names:

  • zero-coupon bonds
  • strip or stripped bonds
  • coupon or residual bonds
  • discount bonds

Compounding or zero-coupon bonds became available in Canada in 1982. Prior to the creation of zero-coupon bonds, investors used conventional bonds, which consists of a series of periodic interest or coupon payments plus the repayment of the bond’s principal at maturity.

In the years prior to the use of computers for maintaining records, bond certificates were issued to bondholders. Attached to each certificate were coupons that represented all the future periodic interest payment to be paid to the investor. To collect the periodic payments, a bondholder would need to clip the individual coupon for the payment period, from the bond certificate and present it for payment.  Therefore, each bond certificate was viewed as having two distinct components:

  • the coupons represented the periodic interest payments, and
  • the certificate itself, represented the repayment of the bondholder’s principal

With computerization came the ability for investment dealers to separate and sell each distinct component as independent investments. The investment dealer holds the physical bond certificate, separates or strips the periodic payments or coupons from the bond, and markets the two components separately. As a result, compounding bonds are not in certificate form but are referred to as book based.This means bond ownership records are maintained by computer and no compounding bond certificates actually exist.

A zero-coupon or stripped bond is created when an investment dealer divides a conventional bond into its two basic constituents:  the periodic payments and the bond principal. These are then sold separately to investors at a discount to their face values, with the bond residual component trading as a stripped zero-coupon bond and each coupon also trades as a stripped zero-coupon bond. 

As the names for these bonds suggest, a zero-coupon bond has no periodic interest payments. It has only a single payment, which includes the repayment of principal at maturity. An investor purchases a zero-coupon bond at a discount to its face or maturity value and then redeems the bond at its face value at maturity. The investor’s interest rate of return is the difference between the face value of the bond and its discounted purchase price. As with conventional bonds, zero-coupon bonds are priced and trade in terms of $100 face value.

Example: Let’s assume an investor purchases a zero-coupon bond with the following characteristics:

  • Face/Maturity Value: $10,000.00
  • Maturity Date: 15 November 2018
  • Purchase Price:  $ 66.81 per $100 face value
  • Purchase Date:    31 December 2009
  • Yield to Maturity: 4.65%
  • Commission:  Included in the purchase price so yield is net of investment costs.

Because the bond’s price is expressed in $100.00 units, to calculate the total purchase price of the zero-coupon bond the investor needs to first divide the quoted purchase price by 100 and then multiply the bonds face value by this number.

Example: $66.81 divided by $100 equals $0.6681. This number multiplied by the face value of $10,000 calculates a purchase cost of $6,681.00.

The yield on zero-coupon bonds is compounded on a semi-annual basis.

A zero-coupon bond’s characteristics are very similar to those of the Government of Canada Treasury Bills except that a zero-coupon bond can have a maturity date that exceeds one year.

Note: Zero-coupon bonds characteristics are very similar to those of compounding Canada Savings Bonds and compounding Guaranteed Investment Certificates (GICs). All of these investments have only one single payment at maturity, with no periodic coupon or interest payments. Government and corporate bond issuers do not issue zero-coupon bonds in Canada. 

Tax considerations for compounding bonds

Revenue Canada categorizes the difference between the purchase price of a zero-coupon bond and the amount received at maturity as deemed interest income for income tax purposes. For an investor holding a zero-coupon bond to maturity within a taxable account, part of the deemed interest must be reported as interest income on an annual basis even though the investor does not receive the money until the bond matures and no income tax slips are issued. In addition to the investor paying income tax on income they do not receive until a future date, the annual deemed interest will not be included in the account’s T5 Income Tax Information Slip or the Summary of Capital Transactions. As a result, the investor will need to manually calculate the annual deemed interest income, claim this amount each year leading to the bond’s maturity. Upon the zero-coupon bond’s maturity, the account’s Summary of Capital Transactions will include the difference between the purchase price and the bonds maturity value as taxable income. As a result, the investor will need to manually reduce the interest income amount by the deemed interest income claimed in prior periods.

If a zero-coupon bond is sold prior to its maturity date, part of the difference between the purchase price and the sale price of the bond is considered deemed interest income, and part is considered either a capital gain or a loss depending on the difference between interest rates when the bond was purchased and the prevailing interest rates at the time the bond is sold.  For income tax purposes, upon maturity or sale prior to maturity, the bond will be listed in the taxable account’s Summary of Capital Transactions and the difference between purchase price and maturity/sale proceeds will be listed and the investor will need to add the difference to their income tax return, adjusted for the deemed interest income claimed in prior periods. 

Due to the difficult accounting for taxable interest income earned from compounding bonds, investors typically restrict holding such bonds in non-taxable accounts such as Registered Education Savings Plans (RESP), Tax Free Savings Accounts (TFSA), Registered Retirement Savings Plans (RRSP), Registered Retirement Income Funds (RRIF), Individual Pension Plans (IPP), etc.

 

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