Changing interest to capital gains
These fixed-income mutual funds use complex derivative strategies to “recharacterize” income
By Jade Hemeon | December 2010
Clients and financial advisors searching for healthy yields in today’s low-interest environment may want to consider the growing number of fixed-income funds that are “recharacterizing” interest income as capital gains. With capital gains being taxed at roughly half the rate of interest income, these investment funds allow your clients to keep considerably more of what they make.
Derek Green, president of Toronto-based CI investments Inc., a division of CI Financial Corp., says two stock market crashes in the past decade have led some investors to shy away from stocks with frightening volatility. Worried about preserving capital for retirement, baby boomers are flocking to fixed-income investments for greater stability.
The problem is that interest income paid by bonds, money market instruments and regular fixed-income mutual funds is taxable at the highest rate, and clients in the highest tax bracket who hold fixed-income investments outside a registered plan are losing almost half of what are already skimpy returns once they pay their income taxes.
“We look at fully taxable, interest rate income as ‘bad income’,” says Green. “With yields being where they are, people are looking for ways to maximize investment income, and if they can. If you can double your after-tax return, that’s a significant advantage.”
These tax-advantaged funds employ derivative strategies to generate payments subject to capital gains from funds that are designed to match the return of a traditional income-producing fund within the same fund family. These specialized funds are offered by a number of fund companies, including CI, Franklin Templeton Investments Corp., Fidelity Investments Canada ULC, Mackenzie Financial Corp., NexGen Financial LP (all of To-ronto) and Excel Funds Manage-ment Inc. of Mississauga, Ont.
For example, the recently introduced Templeton Global Bond Hedged Yield Class fund aims to provide a tax-efficient return based on its “reference fund,” the more traditional Templeton Global Bond Fund. The hedged fund does this by investing in a portfolio of Canadian equities, then using forward contracts to sell the equities to a counterparty, such as a major bank, for a cash payment tied to the value and return of the reference fund.
“These funds,” says Rudy Luukko, investment funds and personal finance editor with Toronto-based Morningstar Canada, “are designed to have a level of volatility consistent with fixed-income while producing a return in the form of tax-advantaged capital gains. Investors are not taking the risks associated with equities.”
The traditional Templeton fund invests in the bonds of countries in which interest rates are higher than in North America, including South Korea, Indonesia, Poland, Mexico, Brazil, Australia, Russia, Malaysia and Hungary. As of Oct. 31, it had an average annual five-year return of 8.3%. It is currently the biggest seller within the Franklin Templeton network.
Franklin Templeton has seven income-advantaged funds, covering Canadian government bonds, corporate bonds and short-term bonds, Canadian and U.S. money market bonds, and global bonds. All seven funds are contained in Franklin Templeton’s corporate-class structure, which allows the additional benefit of tax-deferred switching between funds.
Derek Green, president of Toronto-based CI investments Inc., a division of CI Financial Corp., says two stock market crashes in the past decade have led some investors to shy away from stocks with frightening volatility. Worried about preserving capital for retirement, baby boomers are flocking to fixed-income investments for greater stability.
The problem is that interest income paid by bonds, money market instruments and regular fixed-income mutual funds is taxable at the highest rate, and clients in the highest tax bracket who hold fixed-income investments outside a registered plan are losing almost half of what are already skimpy returns once they pay their income taxes.
“We look at fully taxable, interest rate income as ‘bad income’,” says Green. “With yields being where they are, people are looking for ways to maximize investment income, and if they can. If you can double your after-tax return, that’s a significant advantage.”
These tax-advantaged funds employ derivative strategies to generate payments subject to capital gains from funds that are designed to match the return of a traditional income-producing fund within the same fund family. These specialized funds are offered by a number of fund companies, including CI, Franklin Templeton Investments Corp., Fidelity Investments Canada ULC, Mackenzie Financial Corp., NexGen Financial LP (all of To-ronto) and Excel Funds Manage-ment Inc. of Mississauga, Ont.
For example, the recently introduced Templeton Global Bond Hedged Yield Class fund aims to provide a tax-efficient return based on its “reference fund,” the more traditional Templeton Global Bond Fund. The hedged fund does this by investing in a portfolio of Canadian equities, then using forward contracts to sell the equities to a counterparty, such as a major bank, for a cash payment tied to the value and return of the reference fund.
“These funds,” says Rudy Luukko, investment funds and personal finance editor with Toronto-based Morningstar Canada, “are designed to have a level of volatility consistent with fixed-income while producing a return in the form of tax-advantaged capital gains. Investors are not taking the risks associated with equities.”
The traditional Templeton fund invests in the bonds of countries in which interest rates are higher than in North America, including South Korea, Indonesia, Poland, Mexico, Brazil, Australia, Russia, Malaysia and Hungary. As of Oct. 31, it had an average annual five-year return of 8.3%. It is currently the biggest seller within the Franklin Templeton network.
Franklin Templeton has seven income-advantaged funds, covering Canadian government bonds, corporate bonds and short-term bonds, Canadian and U.S. money market bonds, and global bonds. All seven funds are contained in Franklin Templeton’s corporate-class structure, which allows the additional benefit of tax-deferred switching between funds.