RETAIL BONDS: BE CAREFUL OF THE UNINTENDED CONSEQUENCE

Retail bonds have become a darling of the South African investment community, and with yields recently still close to 12%, demand has soared. We regularly get requests from clients to re-direct investments to retail bonds, understandably so.

There are numerous benefits to investing in retail bonds ranging from their safety (as long as the SA government remains in a position to honour the payment of the yield and capital at the end of the term) to competitive yields. The only real negative aspect of retail bonds is the tax implication, and it is often underestimated what impact it has on an investor’s overall tax situation.

In the tables below, I have sketched a situation where a client wishes to enhance their income by investing R3 million into retail bonds and have the yield (income) paid out monthly. This would increase their current income of R600 000 (derived from drawing 4% against a living annuity of R15 million) and R180 000 received from a rental property they own.

The intention is to increase their gross income from R780 000 per year by R330 000 per year through an investment of R3 million at the current July yield of 11%. The R3 million would be funded by withdrawing funds from their voluntary investment of R6 million.

Below I have created three scenarios, the first illustrating their current situation with a living annuity and property rental income providing their total annual income needs. In the second scenario, I added the  3 million retail bond with an annual income/yield of R330 000, and in the third scenario, their overall portfolio was re-engineered to try and achieve a more tax-efficient annual income.

Let’s take a look at each scenario. 

The scenario above is self-explanatory. Gross income amounts to R780 000, and the subsequent net tax (after allowed rebates and deductions) amounts to  200 035, which equates to an average tax rate of 25.64%. Their marginal tax rate is 39%, which means any additional taxable income will be taxed at 39%. Nothing fancy or strange here.

Now let’s add the R3 million retail bond to the above and observe their tax situation in Scenario 2. 

From the above, we can see that their gross income has increased to R1 110 000 as intended, and their average tax rate has increased to 29.26%, as can be expected, with their marginal tax rate creeping up to 41%. Disposable income amounts to R785 175. At first sight, this does not seem too bad. However, the additional interest provided by the retail bond has also increased the tax payable on the living annuity, and all future additional taxable or deemed taxable income will now be taxed at 41%.

Considering the above, we looked at a way to achieve their income goal of as close as possible to R800 000 per year after tax. If we could achieve this by attracting less tax, it would mean that less capital would be used annually to fund their income. We achieved this by tweaking where the income will be derived and by introducing a “looping strategy”. Observe Scenario 3:

The figures above show that a slightly higher after-tax income/drawing amount can be achieved with less capital drawn by adopting the following strategy:

• Reduce the living annuity income to 2.5% per year.

• Remove the retail bond.

• Replace the income of the proposed retail bond by making regular withdrawals totalling R330 000 per year from the voluntary investment of R6 million. This will create CGT, but CGT is less than income tax.

• Include a looping structure.

In Scenario 3, drawings from investments amounting to R705 000 will be required. That equates to 3.36% of the investment value (living annuity + voluntary funds, R15 million + R6 million).

In Scenario 2, drawings from investments amounting to R600 000 will be required. That equates to 3.33% of the investment value (living annuity + voluntary funds, R15 million + R3 million (R 3 million used to buy retail bonds). This may seem like the same as Scenario 3 but remember, the retail bonds will pay out after five years at par value. That means that the capital value of R3 million will effectively lose its purchasing power at the rate of inflation. That means that the R3 million will be worth R2.2 million (in today’s value) in five years if inflation averages 6% per year. Given the current high yields, it is unlikely that they will repeat at these levels in five years.

The scenario is not much different as far as the voluntary investment are concerned since we are going to draw R330 000 per year to distribute to the investor. The R330 000 equates to 5.5% of the R6 million investment value and should retain its  3 million real value with decent returns. The big winner in Scenario 3 is the reduction of the living annuity income from 4% to 2.5%. This amounts to R225 000 per year which is drawn less. This amount will also increase as the living annuity value increases. Over five years, this additional amount that remained invested and the upside of returns on a portfolio where less is drawn places Scenario 3 way ahead of Scenario 2.

In summary, the benefits of Scenario 3 over Scenario 2 are as follows:

• After tax income increased from R785 175 to R820 558.

• The pre-tax drawing is reduced in Scenario 3 if you take the purchase of the retail bond in Scenario 2 into consideration.

• Tax reduced from R324 825 (29.26%) to R64 442 (11.61%), a saving of R260 383 tax.

• The marginal tax rate reduced from 41% to 31%.

• No voluntary funds are tied up for five years as required by retail bonds.

• The capital value of the overall investments will be higher after five years in Scenario 3 than in Scenario 2.

Note: Where income from a retail bond is relied upon, and the income flows can be offset against a tax-deductible expense like a retirement annuity, effectively reducing the average tax rate (and thereby the marginal tax rate), then retail bonds make a lot of sense. The closer the deductible amount gets to the actual retail bond yield, the more attractive retail bonds become.

I must state that the above is applicable where a high level of tax is payable by an individual, and the intention is that a large amount of funds gets allocated to retail bonds. Where an investor’s average tax rate is well below 20% after acquiring the retail bonds, they make more sense. For taxpayers who approach a 30% + average tax rate before acquiring retail bonds, there are most certainly options that make more sense than a high allocation to retail bonds.

The illustration in Scenario 3 also supports my previous comments that one should try and achieve an investment portfolio where 50% of your funds are invested in retirement funds, with the other 50% in voluntary funds. The investment structuring flexibility that one achieves when you retire should place you in a much more tax-efficient position than drawing income from only pure income taxable sources. Paying CGT is much more efficient than paying income tax.

Retail bonds are fantastic for a five-year investment strategy if you can reduce the tax created. Given the uncertainty of future yields, I am not convinced that they offer the best solution for long-term income requirements. The perfect scenario is where tax can be eliminated, and the yield gets rolled up in the investment for five years effectively increasing your 11% interest due to the effect of compounding interest – that is a winner and a great five-year solution!

Be mindful of the implications of increasing your marginal tax rate because, remember, that is the rate that all future additional taxable income which includes annuity income, rental income and interest earned will be taxed. Avoid the tax monster, invest wisely…

Stay warm and happy investing.