Q: I am considering purchasing U.S. corporate bonds (individual) for the first time. I am thinking that these would be best suited to my RRSP. Can you please advise if I am misguided—and what the pitfalls of my plan might be?
—Beth, 55, in Toronto
A: There are three parts to Beth’s question, first; is it a good idea to hold U.S. bonds? The benefits include diversification of your fixed income portfolio and the possibility of capturing higher interest rates in the U.S. than in Canada. The biggest drawback is the currency risk you accept when you purchase U.S. bonds. While this is true of any U.S. dollar denominated investment, at current low interest rates even a small change in the exchange rate can eliminate the gains from interest income.
Without more information we can’t know the suitability of U.S. bonds for Beth’s portfolio but generally speaking I recommend my clients hold their fixed income investments in Canadian dollars. Exceptions include clients with very large portfolios or those who spend a substantial amount of time in the U.S. since currency risk is hedged somewhat if you have annual expenses in U.S. dollars.
The second issue is whether individual bonds are a suitable investment. Unless you buy a large number of U.S. bonds you are accepting the security-specific risk that one or more of the bonds default and you lose your investment. Since an RRSP account is tax exempt you can’t make use of the capital losses to offset taxable capital gains in other accounts. I generally recommend bond index funds to diversify fixed income holdings.
Third is the tax implication of holding U.S. bonds in a RRSP account. Investors who purchase a bond are entitled to regular interest payments until the bond matures and the loan is repaid. Since interest income is fully taxable it’s often advisable to hold bonds in registered accounts like RRSPs and TFSAs. With U.S. bonds however there is another tax wrinkle; the IRS mandates a 15% withholding tax on the interest paid by the bond.
Due to a tax treaty between Canada and the U.S., retirement accounts are exempt from this tax, (RRSPs and RRIFs). However, if you purchase a Canadian mutual fund or exchange traded fund (ETF) that invests in U.S. bonds the IRS has no way to determine which units of the fund are held in RRSPs so 15% tax is levied on all interest paid to the fund. This tax is avoided if you hold individual U.S .bonds as Beth is suggesting, (or if you hold a U.S. listed bond ETF).
Ryan Kerr is a fee-for-service MoneySense Approved Financial Planner and Chartered Financial Analyst with Astrolabe Financial Group in Ottawa.