Ontario Opportunity Bonds
Provincial tax break attractive
Ontario's latest budget included the introduction of something called Ontario Opportunity Bonds. The bonds, which will be exempt from Ontario tax, will not be directly offered or guaranteed by the Ontario government. Rather, they will be issued by the Ontario Municipal Economic Infrastructure Financing Authority (OMEIFA). On the surface these new bonds look attractive, but they're not for everyone.
Below are the basic details on the new issue of bonds, which closes soon.
Term: 5 years (mature May 6, 2008)
Interest Rate: 4.25 percent, paid semi-annually in May and November
Compounding: No - simple interest
Available until: May 6, 2003
Further, the interest paid is subject to federal tax but exempt from Ontario tax.
Just as mutual funds are sold by prospectus, these bonds are sold via an Information Statement. I would encourage anybody considering these bonds to read it before buying.
After-tax yield comparisons
GICs, investment funds, conventional bonds, strip bonds, real return bonds, preferred shares, provincial and federal savings are common fixed income investments but this is not a complete list. When reviewing various fixed income options, one must be careful to ensure that comparisons are fair and accurate. There are two issues to address when doing comparisons: reinvestment and taxation.
With sufficiently large amounts of money, income spun off from things like preferred shares and conventional bonds can be reinvested in the same or similar type of investment. But without the availability of new Ontario Opportunity Bonds, reinvestment simply isn't an option, no matter what the amount.
If deciding between buying these new bonds or Ontario strip bonds, a yield adjustment is necessary. The yield on strip bonds, because the interest is built into the price paid, is already stated in compound annual terms. Ontario Opportunity Bonds, on a compound annual basis, offer a yield of 3.93 percent, before taxes.
Conventional bonds, which also pay semi-annual interest, are directly comparable and yield an average of 4.18 percent quoted as of May 1 for government of Canada bonds. But such conventional bonds can be sold at any time because they are very liquid - not so with Ontario Opportunity Bonds.
Taking taxes into consideration gets a little trickier. Ontario's highest tax bracket for 2003 kicks in at a taxable income of $104,649. At that level, these bonds will be relatively attractive since they'll attract tax at an effective rate of 29 percent, versus the 46.41 percent applied to regular interest and 31.34 percent rate attached to dividends.
While the rates are slightly different, this is the case for taxable incomes of at least $70,000 or so. Below that, dividend income is taxed much more favourably, though it carries somewhat higher risk.
At lower levels of income - i.e. $25,000 - the tax break shrinks and the mechanics of dividend taxation make dividends a better deal, in my opinion. In this case, dividends are taxed at a rate of just 4.48 percent while interest from these bonds would attract tax at a rate of 16 percent.
It should be very clear at this point that comparisons are very individualistic.
Once purchased, there is no organized market to facilitate the trading of these bonds. Investors are always free to privately sell their bonds to others, but no real market will necessarily exist for such purposes.
Hence, don't count on any opportunity to sell these before their five-year term expires.
OMEIFA's basic purpose is to make it easier and cheaper for Ontario municipalities to borrow money. OMEIFA will borrow funds from the general public through the sale of these Ontario Opportunity Bonds. The rate payable on these bonds, which is 4.25 percent per year, is also OMEIFA's cost of acquiring funds. Further, up to 50 percent of the interest costs on loans from OMEIFA to municipalities are expected to be subsidized by the Ontario government through subordinated loans to OMEIFA. The result: municipalities pay a lower rate of interest to OMEIFA, than if they raised money through traditional means.
Most of OMEIFA's assets and cash flow will be dependent on amounts receivable from the municipalities to which it lends money. Put another way, OMEIFA's credit rating will be a reflection of the credit ratings of the various municipalities. Despite their name, these bonds should not be associated with the province - in terms of safety - because they provide no guarantee of interest or principal for these bonds.
The nature of the tax exemption is awkward. When filing a tax return, investors must claim the full amount of interest, and pay tax thereon at both the federal and provincial levels. Ontario will then deem the provincial tax on the interest from these bonds to be an "overpayment of tax", resulting in a refund. The refund, however, won't be received until six to eight months after tax returns are filed.
These bonds are most suitable for higher income investors wishing to hold safer investments outside of tax-deferred savings plans. For the middle-to-low income class, the attractiveness of these bonds diminishes. For everybody else, there's no rule of thumb, so keep in mind the limitations with respect to liquidity and the potential default risks. As a result, make sure the after-tax yield that you will enjoy sufficiently compensates for these limitations and risks.
Ontario Opportunity Bonds
Information Statement (pdf)
Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at firstname.lastname@example.org
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