NIN 95/09 - Government Strip Bonds - Information Statement Local Policy Statement 3-43 Blanket Order #91/12 [NIN - Rescinded]
| Published Date: | 1995-02-10 |
|---|---|
| Effective Date: | 1995-02-08 |
Local Policy Statement 3-43 and Blanket Order #91/12 permit trades in government strip bonds to first time purchasers only if an information statement approved by the Commission or Superintendent is delivered to such purchasers.
On February 1, l995, the Commission approved the attached revised information statement filed on behalf of the Investment Dealers Association of Canada (the "IDA") for use by IDA members in respect of trades in government strip bonds as defined in LPS 3-43 and BOR#91/12. At the same time the Commission revoked the approval granted in respect of the information statement previously filed by the IDA for trades in government strip bonds made by IDA members on or after February 20, l995.
The Commission hereby approves the use of an information statement that does not differ in any material way from the revised information statement approved on behalf of the IDA. The approval granted in Part 4 of LPS 3-43 in respect of the information statement previously filed and set out in Appendix A of LPS 3-43 is hereby revoked for all trades in government strip bonds made on or after February 20, l995. The Commission will be revising LPS 3-43 to replace the information statement set out in Appendix A with the revised information statement.
BOR#91/12 contains registration and prospectus exemptions for trading and distribution of government strip bonds. In NIN#91/23, the Commission requested comment on its proposal to remove the registration exemption. The Commission has determined that government strip bonds are sufficiently complex that only persons who are subject to the educational, suitability and other requirements imposed on registrants should be permitted to trade government strip bonds. As the Commission has not received any negative comments with respect to its proposal to remove the registration exemption, the Commission will be revising LPS 3-43 and replacing BOR#91/12 to implement its proposal. Interested persons that may be adversely affected by this proposal are requested to advise Brenda Benham, A/Director, Policy & Legislation by facsimile at (604) 660 - 2688 as soon as possible.
DATED at Vancouver, British Columbia on February 8, l995.
Douglas M. Hyndman
Chair
Attachment
References: BOR#91/12
LPS 3-43
NIN#91/23
STRIP BONDS AND STRIP BOND PACKAGES
INFORMATION STATEMENT
This Information Statement is being provided as required by securities regulatory authorities in Canada to describe certain attributes of "strip bonds" and "strip bond packages".
Strip Bonds and Strip Bond Packages
In this Information Statement the term "strip bond" refers to an interest in either (i) the amount payable on account of principal, or (ii) an amount payable on account of interest, in respect of one or more "Underlying Bonds". An Underlying Bond is a debt security issued or guaranteed by the government of Canada, a province of Canada or a foreign country or political division thereof and which pays interest at a fixed rate and at regular intervals. (Please note that: in New Brunswick and Quebec, only strip bonds in respect of Underlying Bonds issued or guaranteed by the government of Canada or a province of Canada are eligible for exemption from the registration and prospectus requirements of the applicable securities legislation; in Manitoba the exemption is limited to Underlying Bonds described in Section 19(2)a of the Securities Act (Manitoba); and in British Columbia the exemption is limited to Underlying Bonds of or guaranteed by the government of Canada or a province of Canada or a country or political subdivision of a country recognized by the British Columbia Securities Commission in an order made under section 32(a)(i.1) of the Securities Act (British Columbia).)
A strip bond entitles the holder to a single payment of a fixed amount in the future without the payment of any interest in the interim. The purchase price or present value of a strip bond is determined by discounting the amount of the payment to be received on the payment or maturity date of the strip bond by the appropriate interest rate or yield factor. Strip bonds are therefore different from conventional interest-bearing debt securities and purchasers of strip bonds should be aware of the special attributes of strip bonds as described in this Information Statement. Strip bonds may be purchased in various different forms as described below under "Custodial Arrangements".
In this Information Statement the term "strip bond package" refers to a security comprised of two or more strip bonds which are combined to make up a "bond-like" strip bond package or an "annuity-like" strip bond package. A bond-like strip bond package consists of an interest in the principal amount payable in respect of one or more Underlying Bonds, together with one or more interests in the interest payments to be made on one or more Underlying Bonds, thereby creating an instrument that resembles, in its payment characteristics, a conventional bond. An annuity-like strip bond package differs from a bond-like strip bond package only to the extent that it does not include an interest in the principal amount payable in respect of one or more Underlying Bonds. Strip bond packages may be purchased in the form of several separate strip bonds or as one security in one of the forms described below under "Custodial Arrangements".
Price Volatility
As with conventional interest-bearing debt securities, the market price of strip bonds and strip bond packages will fluctuate with prevailing interest rates. Generally, the market price of conventional interest-bearing debt securities and of strip bonds and strip bond packages will fluctuate in the same direction: when prevailing interest rates rise above the yield of these instruments, their market price will tend to fall; conversely, when prevailing interest rates fall below the yield of these instruments, their market price will tend to rise.
However, the market price of a strip bond will be significantly more volatile than the price of a conventional interest-bearing debt security with the same credit risk and term to maturity. When prevailing interest rates rise, the market price of a strip bond will tend to fall to a greater degree than the market price of a conventional interest-bearing debt security with the same credit risk and term to maturity. Conversely, when prevailing interest rates fall, the market price of a strip bond will tend to rise to a greater degree than the market price of a conventional interest-bearing debt security with the same credit risk and term to maturity. The primary reason for such volatility is the fact that no interest is paid in respect of a strip bond prior to its maturity. There is, therefore, no opportunity to reinvest interest payments at prevailing rates of interest prior to maturity.
The table below compares changes in the prices of conventional interest-bearing debt securities and strip bonds. The table shows, on a hypothetical basis, the difference in price fluctuation as a result of fluctuations in prevailing interest rates between, on the one hand, 5-year and 20-year $1,000 face amount conventional bonds bearing interest at 10% payable semi-annually, and, on the other hand, 5-year and 20-year $1,000 face amount strip bonds priced to yield 10%. It will be noted that the longer the term to maturity of the bond or the strip bond, the more volatile its market price will be.
| Market Price Volatility (expressed as a percentage of face amount) |  | | | | | |
| Market Price | Market Yield | Price with Rate Drop to 7% | % Price Change | Price with Rate Increase to 13% | % Price Change |
| 10% 5 Year Bond | $100.00 | 10.00% | $112.47 | +12.47% | $89.22 | -10.78% |
| 5 Year Strip Bond | 61.39 | 10.00 | 70.89 | +15.47 | 53.27 | -13.23 |
| 10% 20 Year Bond | 100.00 | 10.00 | 132.03 | +32.03 | 78.78 | -21.22 |
| 20 Year Strip Bond | 14.20 | 10.00 | 25.26 | +77.89 | 8.05 | -43.30 |
In contrast to strip bonds, the income stream received on a strip bond package prior to maturity or the final payment date may be reinvested at the then prevailing interest rates. Therefore, the market price of a strip bond package will not be as volatile as the market price of a strip bond with the same credit risk and term to maturity or final payment date. However, it may be more volatile than the market price of a conventional interest-bearing debt security with the same credit risk and term to maturity.
Secondary Market and Liquidity
Strip bonds and strip bond packages do not trade in Canada in an auction market similar to that for shares listed on a stock exchange. Instead, strip bonds and strip bond packages trade in dealer or over-the-counter markets similar to those for most conventional debt securities. Certain strip bonds and strip bond packages that are available in Canada are offered by groups of investment dealers or financial institutions which may make markets for the strip bonds and strip bond packages they offer, although they are not obligated to do so. There can be no assurance that a market for particular strip bonds or strip bond packages will be available at any given time. In such circumstances, purchasers may have to hold their strip bonds and strip bond packages to maturity or final payment date in order to realize their investment.
Custodial Arrangements
Purchasers may purchase strip bonds and strip bond packages in four forms:
- A deposit receipt or certificate issued by a custodian where the receipt or certificate represents the relevant segregated underlying interest coupon(s) or principal residue(s) held by the custodian (alter-ego receipt).
- A deposit receipt or certificate issued by a custodian where the receipt or certificate represents an undivided interest in a pool of coupons or residues held by the custodian or in interest or principal payments to be made in respect of one or more Underlying Bonds held by the custodian (non alter-ego receipts).
- A book-entry position created by The Canadian Depository for Securities Limited ("CDS") which represents an undivided interest in the relevant interest or principal payment(s) to be made in respect of one or more Underlying Bonds held by CDS.
- In limited circumstances, physical delivery of the actual coupon(s) or residue(s) (in specie).
Each of these forms has different characteristics:
- Alter-ego receipts may entitle the holder to take physical delivery of the underlying coupon(s) or residue(s). If the holder decides to take physical delivery, the holder should be aware of the high risks associated with holding a bearer security which cannot be replaced. The holder also should be aware that the secondary market for physical strip bonds may be more limited than for other forms of strip bonds and strip bond packages, due to the risks involved.
- For alter-ego receipts and non alter-ego receipts, registered certificates may be available to the holder on request. Where registered certificates are not available under the custodial arrangements for the strip bond or the strip bond package, the holder will receive periodic statements showing the security position from his or her investment dealer or other financial institution.
- Holders of non alter-ego receipts and book-entry positions are not entitled to take physical delivery of the underlying coupon(s) or residue(s), except in cases where specifically allowed by the custodial arrangements or the rules of CDS, as the case may be.
- Holders of alter-ego receipts, non alter-ego receipts and book-entry positions, and holders of physical coupons(s) and residue(s), may be limited in their right to enforce the terms of the Underlying Bond(s) directly against the issuer. Further, such holders may have their rights under applicable custodial arrangements and in respect of the Underlying Bond(s) affected by a specified majority of such holders. Voting rights may be allocated to holders of strip bonds and strip bond packages based on a formula specified as part of the relevant custodial arrangement or as specified in the terms of the Underlying Bond(s). Each purchaser should review the relevant custodial arrangements and the purchaser's rights thereunder.
In some cases the Underlying Bonds are redeemable or callable prior to maturity. Purchasers of strip bonds or strip bond packages relating to interest payments to be made in respect of Underlying Bonds that are redeemable or callable should satisfy themselves that such interest payments do not relate to interest payment dates that may occur after the Underlying Bond's earliest call or redemption date.
Canadian Income Tax Summary
The Canadian federal income tax consequences of purchasing strip bonds and strip bond packages are complex. Purchasers of strip bonds and strip bond packages should consult their own tax advisors for advice relating to their particular circumstances. The following summary is intended to be a general commentary on the attributes of strip bonds and strip bond packages under the Income Tax Act (Canada) ("Tax Act") and the regulations thereunder ("Regulations") for purchasers who hold their strip bonds and strip bond packages as capital property for purposes of the Tax Act.
Qualified Investments
Strip bonds and strip bond packages relating to Underlying Bonds that are issued or guaranteed by the government of Canada or issued by a province of Canada are "qualified investments" eligible for purchase by trusts governed by registered retirement savings plans ("RRSPs"), registered retirement income funds ("RRIFs") and deferred profit sharing plans ("DPSPs").
Annual Taxation of Strip Bonds
Revenue Canada has indicated that purchasers of strip bonds will be treated as having purchased a "prescribed debt obligation" within the meaning of the Regulations. Accordingly, a purchaser will be required to include in income in each year a notional amount of interest, notwithstanding that no interest will be paid or received in the year (see example below). Therefore, these instruments may be more attractive to non-taxable accounts, such as self-directed RRSPs, RRIFs, DPSPs, pension funds and charities, than to taxable accounts.
In general terms, the amount of notional interest deemed to accrue each year will be determined by using that interest rate which, when applied to the original purchase price and compounded at least annually, will result in a cumulative accrual of notional interest from the date of purchase to the date of maturity equal to the amount of the discount from face value at which the strip bond was purchased.
For individuals and certain trusts, the required accrual of notional interest in each year is generally only up to the anniversary date of the issuance of the Underlying Bond. For example, if a strip bond is purchased on February 1 of a year and the anniversary date of the issuance of the Underlying Bond is June 30, only five months of notional interest accrual will be required in the year of purchase. However, in each subsequent year, notional interest will be required to be accrued from July 1 of the previous year to June 30 of the subsequent year.
The table below sets out the income tax treatment of a taxable individual investor resident in Canada who purchases a $5,000 strip bond on February 1, 1995 at a cost of $3,256.69. The anniversary date of the issuance of the Underlying Bond is June 30. The strip bond is due on June 30, 2000 (i.e. 5 years and 5 months later) and the investor holds it to maturity. Thus, the effective interest rate on the strip bond for purposes of the interest accrual rules will be 8.25%. The investor's marginal tax rate is assumed to be 53%.
| Year | Base for interest compounding (i.e. purchase price plus previously accrued notional interest) | Accrued notional interest for year (i.e. 8.25% of the base for interest compounding except in the first year) | Tax Liability at 53% |
| 1995 | $3,256.69 | $107.11* | $ 56.77 |
| 1996 | 3,363.80 | 277.51 | 147.08 |
| 1997 | 3,641.32 | 300.41 | 159.22 |
| 1998 | 3,941.72 | 325.19 | 172.35 |
| 1999 | 4,266.92 | 352.02 | 186.57 |
| 2000 | 4,618.94 | 381.06 | 201.96 |
| | $1,743.30 | |
| * [(1.0825) 149/365 x $3,256.69] - $3,256.69 Note: February 1, 1995 to June 30, 1995 = 149 days because the investor is not credited with interest for the day of purchase | | | |
In some circumstances the anniversary date of the issuance of the Underlying Bond may not be readily determinable. In these circumstances individual investors may wish to consider accruing notional interest each year to the end of the year.
A corporation, partnership, unit trust or any trust of which a corporation or partnership is a beneficiary is required for each taxation year to accrue notional interest to the end of the taxation year and not just to an earlier anniversary date in the taxation year.
Disposition of Strip Bonds Prior To Maturity
Upon the disposition of a strip bond prior to maturity, purchasers will be required to include in their income for the year of disposition notional interest to the date of disposition. If the amount received on such a disposition exceeds the total of the purchase price and the amount of all notional interest accrued and included in income, the excess will be treated as a capital gain.
If the amount received on disposition is less than the total of the purchase price and the amount of all notional interest accrued and included in income, the difference will be treated as a capital loss. As of the date of this Information Statement, a taxpayer was required to take into account three quarters of the capital gain or loss in determining taxable income.
The table below sets out the income tax treatment for the individual investor in the previous example where the investor sells the strip bond on September 30, 1997 for an assumed sale price of $4,321.26.
| Proceeds of disposition | | $4,321.26 |
| Base for calculation of capital gain · initial cost · accrued income for 1995 (see previous table) · accrued income for 1996 (see previous table) · accrued income for 1997 · to anniversary date (see previous table) · to September 30 | $3,256.69 107.11 277.51 300.41 73.49* | 4,015.21 |
| Capital gain | | 306.05 |
| Taxable capital gain (3/4 of capital gain) | | 229.54 |
| * [(1.0825) 92/365 x $3,641.32] - $3,641.32 | | |
Strip Bond Packages
Because a strip bond package consists for tax purposes of a series of separate strip bonds, the interest inclusion rules will be satisfied if an annual notional interest inclusion is determined in respect of each separate strip bond as outlined above. However, the calculation of such annual notional interest inclusion may be very complex. In addition, the calculation may be impossible to perform for individual purchasers to the extent that the anniversary dates of the Underlying Bonds are unknown.
As an alternative, purchasers of strip bond packages may wish to consider accruing notional interest to the end of each year at the internal rate of return or yield of the strip bond package determined in respect of the purchaser on the assumption that the strip bond package is held to maturity or final payment date. The use of this method may in some circumstances result in a marginally less favourable income tax result to an individual purchaser than the calculation of an annual notional interest inclusion in respect of each separate strip bond comprising the strip bond package.
Upon the disposition of a strip bond package prior to maturity, purchasers will be required to include in their income for the year of disposition notional interest to the date of disposition. If the amount received on such a disposition exceeds the total of the purchase price and the amount of all notional interest accrued and included in income, the excess will be treated as a capital gain. If the amount received on disposition is less than the total of the purchase price and the amount of all notional interest accrued and included in income, the difference will be treated as a capital loss. As of the date of this Information Statement, a taxpayer was required to take into account three quarters of the capital gain or loss in determining taxable income.
Non-Residents of Canada
Non-residents of Canada for the purposes of the Tax Act who purchase strip bonds or strip bond packages relating to Underlying Bonds issued or guaranteed by the government of Canada or issued by a province of Canada and which were issued after April 15, 1966 will not be liable for income tax in Canada (including withholding tax) on any amounts paid or credited with respect to the strip bonds or strip bond packages if such purchasers do not use or hold the strip bonds or strip bond packages in carrying on business in Canada and their sole connection with Canada is the acquisition and ownership of the strip bonds or strip bond packages.
January 1995.