Clients and financial advisors searching for healthy yields in today’s low-interest environment may want to consider the growing number of fixed-income funds that are “recharacterizing” interest income as capital gains. With capital gains being taxed at roughly half the rate of interest income, these investment funds allow your clients to keep considerably more of what they make.

Derek Green, president of Toronto-based CI investments Inc., a division of CI Financial Corp., says two stock market crashes in the past decade have led some investors to shy away from stocks with frightening volatility. Worried about preserving capital for retirement, baby boomers are flocking to fixed-income investments for greater stability.

The problem is that interest income paid by bonds, money market instruments and regular fixed-income mutual funds is taxable at the highest rate, and clients in the highest tax bracket who hold fixed-income investments outside a registered plan are losing almost half of what are already skimpy returns once they pay their income taxes.

“We look at fully taxable, interest rate income as ‘bad income’,” says Green. “With yields being where they are, people are looking for ways to maximize investment income, and if they can. If you can double your after-tax return, that’s a significant advantage.”

These tax-advantaged funds employ derivative strategies to generate payments subject to capital gains from funds that are designed to match the return of a traditional income-producing fund within the same fund family. These specialized funds are offered by a number of fund companies, including CI, Franklin Templeton Investments Corp., Fidelity Investments Canada ULC, Mackenzie Financial Corp., NexGen Financial LP (all of To-ronto) and Excel Funds Manage-ment Inc. of Mississauga, Ont.

For example, the recently introduced Templeton Global Bond Hedged Yield Class fund aims to provide a tax-efficient return based on its “reference fund,” the more traditional Templeton Global Bond Fund. The hedged fund does this by investing in a portfolio of Canadian equities, then using forward contracts to sell the equities to a counterparty, such as a major bank, for a cash payment tied to the value and return of the reference fund.

“These funds,” says Rudy Luukko, investment funds and personal finance editor with Toronto-based Morningstar Canada, “are designed to have a level of volatility consistent with fixed-income while producing a return in the form of tax-advantaged capital gains. Investors are not taking the risks associated with equities.”

The traditional Templeton fund invests in the bonds of countries in which interest rates are higher than in North America, including South Korea, Indonesia, Poland, Mexico, Brazil, Australia, Russia, Malaysia and Hungary. As of Oct. 31, it had an average annual five-year return of 8.3%. It is currently the biggest seller within the Franklin Templeton network.

Franklin Templeton has seven income-advantaged funds, covering Canadian government bonds, corporate bonds and short-term bonds, Canadian and U.S. money market bonds, and global bonds. All seven funds are contained in Franklin Templeton’s corporate-class structure, which allows the additional benefit of tax-deferred switching between funds.@page_break@“The products are gaining more interest recently,” says Dennis Tew, chief financial officer with Franklin Templeton, “due to the conservative nature of inves-tors and the increasing interest in yield products since the financial meltdown of 2008.”

Excel Funds recently introduced its first emerging-markets income funds, including Excel EM High Income Fund and its tax-efficient version, Excel EM Capital Income Fund. According to market indices, emerging-markets bonds are producing yields in the 6.5% range, compared with a 3.6% average yield on U.S. corporate bonds. The new funds are designed to distribute income monthly, based on a rate of 6% a year. Investors in the tax-advantaged fund would pay taxes on only half their income.

NexGen goes even further than its competitors with its tax strategy, giving investors a variety of choices in the form of income they can choose to receive from NexGen Canadian Bond Fund. For example, investors in the bond fund can choose a version of the fund that converts the interest income to either tax-advantaged dividend income or capital gains. Investors also can choose to take income payments in the form of return of capital, which is tax-deferred until the original principal is used up.

NexGen also offers a “compound growth” class, in which the income is reinvested each year instead of being distributed, and taxes can be deferred for years until the investor exits the fund.

“The rate of return on interest-bearing investments is very low,” says NexGen president Laurie Munro. “To the extent that inves-tors can take off half the tax or defer it, that is to their advantage.”

Tax-advantaged yield funds are also available as exchange-traded funds, with Toronto-based Claymore Investments Inc. offering Claymore Advantaged High Yield Bond ETF, which tracks the Barclays Capital U.S. high-yield very liquid index; and Claymore Advantaged Canadian Bond ETF, which tracks the DEX DLUX capped bond index.

Another benefit of receiving income in the form of capital gains is that it can be used to offset capital losses from previous years, Tew says. Many investors realized losses when they sold stock-related investments after the 2008 market meltdown, and some are reluctant to go back into equities full throttle to generate capital gains that would be tax-free if they are offset against losses generated in the past three years.

Typically, the derivatives used to convert interest income to capital gains add 30 basis points to 50 bps to the management fees of a tax-efficient yield fund, relative to the reference fund. Says Dan Hallett, vice president and director, asset management with HighView Financial Group in Oakville, Ont.: “Due to the costs of derivatives, the higher the yield on the fund and the higher the tax rate of the investor, the bigger the benefit of these funds. If the fund is only paying an income of 2%, it could get to the point at which the structure is not worthwhile after fees.”

Funds using derivatives to recharacterize income must deal with a counterparty in the swap transaction, Hallett adds, which introduces the slight risk of counterparty default. In the event of the counterparty’s bankruptcy — highly unlikely among major Canadian banks — the return of the fund could be at risk, he says, but not the principal. IE