You may have heard of hedging investments using options or perhaps forward contracts. You might even have invested in principal protected notes. Here is a strategy where you can effectively preserve your principal while exposing your investments to the market. This strategy is rather conservative not nonetheless effective for those who are concerned about stock market declines.
How It Works
Assume you have $10,000 to invest and are worried about losing your investments.
First, find a broker selling zero coupon bond. A zero coupon bond is simply a government or corporate bond that has had the interest coupons removed a sold separately. The bond itself trades at a discount. When the bond matures, you receive face value for the bond.
You invest the difference between what you paid for the bond and the $10,000 in stocks or mutual funds.
An Example
You buy a 10 year zero coupon bond for $7,400 and invest the remaining in stocks or equity mutual funds.
After 10 years you will receive the $10,000 face value of the bond and your equity investments should have grown as well.
The Reward
You have preserved or insured the principal of your investment and hopefully have earned investment returns greater than what you would have investing strictly in bonds of fixed income.
The Risks
Nothing in life is guaranteed. Your equity investments may not do as well as you hoped, but history indicates otherwise. Also, the type of bond you buy is important. If you had tried this strategy with a Nortel bond, your insurance is probably worthless.
Income Taxes & The Bond
When you buy a zero coupon bond, the gain between your cost and maturity value is considered interest income. You will be required to accrue and pay tax on the imputed interest on the note annually even though you may not receive face value for several years.
With any investment strategy, take with your advisor or tax professional and know the risks before diving in.
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Sounds like this sort of thing could work well in a TFSA – no taxes on the interest or the gains associated with the associated “insured” investment (potentially high risk / high reward).
Strip bonds can be difficult to figure out from a tax perspective and this type of strategy is probably best done inside a TFSA or another tax-deferred account (RRSP or RRIF).