Some tax-friendly investing alternatives to RRSPs

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The convention wisdom, if you are a Canadian investor, has it that you are far better off keeping your interest-generating investments in a registered retirement savings plan, retirement income fund or a tax free savings account to boost after-tax returns.

But some investors simply don't have enough room in those accounts to hold the full amount that they want to devote to bonds and cash.

These investors, by necessity, end up holding much of their portfolio in taxable accounts including the fixed income assets they need to meet their desired asset allocation mix. Interest income's harsh tax treatment, however, sets many investors on the hunt for more tax friendly ways to invest in fixed income.

If you are one of these investors, you have a few options to consider in your pursuit.

Corporate Class Bond Funds

Mutual funds can be legally structured as trusts or corporations. Mutual fund corporations, which have become more popular in recent years, have different classes of shares offering exposure to various asset classes, for example, Canadian Equity Class, Global Equity Class or Canadian Bond Class. These fund corporations have two tax advantages.

Switching between the asset classes offered by the corporation - say, from Canadian Equity to Canadian Bond - can be done on a tax-deferred basis. As long as any such switching keeps you inside a single corporation, the trade need not be reported on your tax return. You must however report the gain or loss when you exit the corporation entirely.

Each share class's revenues and expenses are aggregated for the entire fund corporation, allowing one class's net loss to offset the net profit of another, making the overall corporation more efficient tax-wise. Since stock funds don't generate a lot of annual taxable income, its expenses can be earmarked to cover the interest generated by the bond share class.

While there are a few fund corporations with pure bond share classes - from companies like CI Investments Inc., Bissett Investment Management (a unit of Franklin Templeton Investments Corp.) and Invesco Trimark Ltd. - they are an endangered species. Only the CI offering is open to new money.

Synthetic Funds

Synthetic bond funds can be either a share class in a mutual fund corporation or a stand-alone fund (for example, mutual, exchange-traded or closed-end) but all use the same basic strategy. These funds don't usually invest in bonds. The source of their tax-friendliness and the "synthetic" label come from their use of derivative contracts - usually forward or swap agreements - which effectively convert interest to lightly taxed capital gains. While the management expense ratios of these funds can be competitive, the costs of derivative contracts are extra, making most of these funds richly priced.

Globeinvestor.com shows the management expense ratio for one of the largest synthetic bond funds at about 1.6 per cent per year. Adding the typical 0.4 per cent in annual derivatives cost brings total annual fees to 2 per cent. Is this extra cost worth the resulting tax benefits? It depends.

After-tax yield comparison of a hypothetical synthetic bond fund vs. a regular (fully taxable) bond fund

*Source: www.iShares.ca accessed on July 26, 2010

**Ontario's highest individual marginal tax bracket of 46.41% is assumed. Synthetic funds are taxed at half of this rate.

The higher the bond yield and the higher your marginal tax rate, the more you should be willing to pay for tax benefits. With today's skinny 3.1 per cent bond yields, I'm hard-pressed to see any value in synthetic funds since the extra 0.4 per cent in annual fees wipes out the tax benefits for most synthetic fund investors (see the table here for a comparison).

If you deal with a financial adviser, you may be better off with a regular corporate class bond fund. Do-it-yourself investors, however, should look at Claymore Investments Inc.'s new synthetic bond exchange-traded funds, which offer reasonable fees and tax efficiency.

Note that the potential risk exposure with synthetic funds is higher so thorough due diligence is a must.

Preferred Shares

Last but not least in the class of tax-friendly bond alternatives are preferred shares (also known as preferreds). These hybrid securities are technically stocks but have bond-like features and price behaviour. Their appeal lies in the dividend tax credit. Since dividend yields on publicly traded preferred shares are typically higher than bond yields and taxed less harshly (thanks to the tax credit), you keep more jingle in your jeans.

But preferreds have risks that are different (and higher) than bonds so you should limit your exposure to less than half of your overall bond exposure to control risk.

There are two preferred share mutual funds (from Omega Funds and Manulife/AIC), an ETF from Claymore and a pooled fund from Hymas Investment Management Inc.

Your individual tax situation will dictate the feasibility of any of these options. Since improving after-tax yields usually involves higher risk and/or fees, make sure you or your financial adviser is capable of doing the work required to assess your options.

Dan Hallett, CFA, CFP is Director, Asset Management for Oakville, Ont.-based HighView Financial Group and contributor to www.thewealthsteward.com