A Tax-Friendly Bond ETF on the Horizon

Bonds should be part of just about every portfolio, but if you have to hold them in a non-registered account the tax consequences can be onerous. Fortunately, Canada’s ETF providers are taking steps to ease that burden with some innovative new products, including an ETF of strip bonds and another that holds only low-coupon discount bonds. The latest entry is the Horizons Canadian Select Universe Bond (HBB), which is set to begin trading this week. HBB is unique: it’s the only bond ETF in North America—and maybe anywhere—that uses a total return swap, which should dramatically improve its tax-efficiency.

The swap structure is the same one used by the Horizons S&P/TSX 60 (HXT) and the Horizons S&P 500 (HXS), which are now more than three years old. Here’s the basic idea: the ETF provider has an agreement with National Bank (called the counterparty) to “swap” the returns of two different portfolios. When you buy units in HBB, Horizons places your money in a cash account and pays the interest to the counterparty. In return, National Bank agrees to pay Horizons an amount equal to the total return of the fund’s index—that means any price change, plus interest payments—minus a 0.15% fee. (This is on top of the 0.15% management fee charged by Horizons, so investors should expect the fund to lag its benchmark by 0.30%, plus a bit more for taxes.)

As an investor in HBB, you therefore have exposure to the bond market, even though you don’t actually own any bonds. This has a couple of important implications. The first is that the ETF won’t pay any cash distributions. More important, you won’t be taxed on the interest each year. That’s because there is no interest: remember, you’re not actually holding any bonds. Investors therefore won’t have any tax liability until they ultimately sell their shares in the ETF, at which point any growth would be taxed as a capital gain.

The potential tax benefit here is significant. A swap-based ETF (like a stock that never pays a dividend) allows the investor to defer taxes indefinitely. And because capital gains are taxed at only half the rate of interest, the investor’s ultimate tax bill could be significantly lower than it would be with a traditional bond fund.

Across the universe

HBB tracks the newly created Solactive Canadian Select Universe Bond Index. The benchmark is similar to the widely followed DEX Universe Bond Index in average term (about 10 years), yield to maturity (about 2.5%) and duration (about 7 years). Both indexes also hold approximately 70% government and 30% corporate bonds, all investment-grade. This means HBB’s pre-tax performance should be very similar to that of the iShares Canadian Universe Bond (XBB) and the BMO Canadian Aggregate Bond (ZAG).

The key difference is that the Solactive index has far fewer bonds: 162 issues, compared with more than 1,300 for the DEX Universe. Tracking a large bond index is difficult and expensive, so index funds pegged to the DEX Universe always use “representative sampling,” selecting a smaller of number bonds with similar overall characteristics. XBB, for example, holds about 800 issues, while smaller funds may hold fewer. The new Solactive index will be easier to replicate in full, while still providing plenty of diversification and liquidity. The index licensing fee is also much lower, which likely helped to keep the management fee down.

What are the risks?

Swap-based ETFs do carry some additional risk investors should understand. The first is counterparty risk: there’s a possibility the counterparty (in this case, National Bank) could fail to deliver the return of the underlying index as promised. Most people would likely agree this risk is small. The probability of a major Canadian bank defaulting seems low, and even if that were to occur, ETF unitholders would not lose their whole investment. Canadian securities law requires mutual funds and ETFs to keep their derivative exposure to no more than 10% of the fund’s assets. At least 90% of the fund’s assets is therefore covered by high-quality collateral. (See my previous posts for more on the risks of swap-based funds from Horizons and synthetic ETFs in general.)

The second risk is that the federal government may decide to crack down on swap-based products. Many investors have asked me about this since the 2013 budget spelled doom for the so-called “Advantaged” ETFs from iShares, which also promised tax-efficient exposure to bonds and foreign equities. No one can predict future government policy, so this is always a possibility, but there are some important differences between total-return swaps and the type of derivative (called a forward contract) used by the Advantaged ETFs. Even if the government did eventually take aim at swap-based ETFs, the likely consequence would simply be that unitholders would have to sell the fund and realize any capital gains immediately.

As always, it’s prudent to take a wait-and-see approach with new products, and to make sure you’re comfortable with the structure of non-traditional ETFs. But if HBB delivers on its promise, it could offer significant benefits for investors who need to hold their fixed income outside registered accounts.

Update: Some clarification from Horizons

After this post was published, I followed up with Horizons regarding the questions raised by readers. Here’s what I learned:

Swaps are different from the forward agreements that were targeted by CRA last year. The forward agreements made an election under Section 39(4) of the Income Tax Act to have their settlement treated as “capital transactions” rather than income gains or losses. These so-called “character conversion transactions” were what the government clamped down on with the 2013 budget announcement.

Swaps do not make this election. Upon settlement of the swap (which can occur any time there is a redemption in the fund), the realized gains are characterized as income. But instead of that income being passed along to individual retail investors, the tax liability is borne by the institutional market makers. The key idea is that no income is being “recharacterized” as capital gains: the market makers and the counterparty do have a tax liability for the income they receive. Presumably as corporations they have the ability to deduct this income as an expense in ways that individual investors do not.

As outlined in the prospectus, there is a possibility that at some point ETF unitholders could receive an income distribution and would be liable for the associated tax. This possibility is remote, however: it would require zero redemptions in the ETF, as well as a significant rise in rates. This is why Horizons ETFs has said they don’t anticipate making any taxable distributions, but cannot guarantee this. The situation is the same with HXS, but so far there have been no distributions in the funds’ three years of existence.


79 Responses to A Tax-Friendly Bond ETF on the Horizon

  1. Canadian Couch Potato May 12, 2014 at 11:19 pm #

    @Linda: I don’t think anyone can accurately estimate the likelihood that the government will crack down on these ETFs. We simply don’t know when or if that will happen. I don’t want to downplay this risk, but I do think it’s important to remember that when they did change the rules on forward-based funds (and income trusts, for that matter) there were no retroactive penalties, and there was ample time for investors to sell the existing products and switch to alternatives. So the risk should be kept in perspective. There may be some forced capital gains to pay, but one would have had to pay those at some point anyway.

  2. Michael James May 13, 2014 at 8:31 am #

    @CCP: It’s true that it is impossible to accurately predict when or if government crack-down on swap-based ETFs, but anyone who simply ignores this possibility and invests is implicitly treating this probability as zero, which is obviously incorrect. We have little choice as rational investors but to work out the likely cost in having to pay capital gains taxes early and assign some probability to tax-rule changes.

  3. Michel May 13, 2014 at 2:12 pm #

    @CCC, i just noticed your answer to Jas regarding the avoidance of swap-based ETFs with its PWL Capital clients. I would like to hear the rationale behind the decision to avoid them. I assume a good portion private wealth management firms hold significant assets in non-registered accounts.

  4. Canadian Couch Potato May 13, 2014 at 2:28 pm #

    @Michel: I can only speak for our practice in Toronto. We choose to hold plain vanilla ETFs in client accounts to keep costs as low as possible. We manage taxes using tax-loss harvesting opportunities and avoiding high-dividend funds in non-registered accounts, etc. Most accounts also include DFA funds, which are very well-managed when it comes to taxes: even their bond fund has a very low coupon, so it’s quite tax-efficient. Or we use GICs for the fixed income portion in non-registered accounts.

    The possibility of a crackdown on swap-based ETFs is an important factor when you’re management large portfolios, since the forced capital gains could be very large.

    This may be of interest:

  5. LJD May 13, 2014 at 5:08 pm #

    Great insight into HBB. Thanks

    In a rising interest rate environment, the investor return from a total return swap based fixed income fund may underperform funds of similar duration and credit quality which pay out distributions due to distributions being reinvested rather than crystalizing in cash, and the compounding there of.

    While the structure seems to fit within the current framework of tax rules, given that it is using tax arbitrage on investment grade fixed income compared to tax advantaged more volatile equities in other Horizons funds, chances are CRA may want to take a closer look at it.

    Also, transaction cost to investors to generate own stream of income

  6. Tristan May 13, 2014 at 9:38 pm #

    @Oldie, Holger: I bought some BXF last July so have received a 2013 T3. There was only other income and return of capital, $0.04487 per share of other income and $0.0083 per share of return of capital.

  7. Oldie May 14, 2014 at 2:54 am #

    @ Tristan: hey, thanks for actual experience reliable tax feedback for 2013, anyway. Shares are selling @ 10.06, call it 10, so 4.49% interest-like return, and 0.83% return of capital — not too shabby, and not from bonds bought at a premium, so the interest tax is “neutral”. Didn’t do too bad! And MER fee holiday until July 2014, too! Hey, return of capital is just that, right? — a refund if you will — do you pay ANY tax on that?

  8. Canadian Couch Potato May 14, 2014 at 9:23 am #

    Note: I followed up with Horizons to get some answers to readers’ questions. A summary of our discussion has been added to the bottom of the original post.

  9. gsp May 14, 2014 at 2:01 pm #

    @Oldie, you’re off by a factor of 10.

    BXF was only around for a little less than 7 months in 2013, hard to imagine how anyone could expect 5+% returns in that timeframe from a fund with a YTM of 1.65% before fees.

    No tax on ROC but it lowers your ACB and if it ever renders it negative, the negative ACB gets taxed as a capital gain.

  10. LJD May 14, 2014 at 2:13 pm #

    Thanks for the clarifications from Horizons and goes without saying that you run a great site.

    As I said in my prior comment, while the structure seems to fit within the current framework of tax rules, given that it is using tax arbitrage (ie. the institution paying lower or no tax in lieu of the retail investor paying at his/her marginal rate on the flow through) on an investment grade fixed income product, chances are CRA may want to take a closer look at it to plug loss of revenue.

  11. Oldie May 14, 2014 at 3:03 pm #

    @gsp: Doh! Thanks for the correction, and elucidation.

  12. Tristan May 14, 2014 at 8:55 pm #

    @Oldie: Sorry, just to clarify. The distribution mentioned above for BXF was the first quarterly distribution in September. There was a similar distribution in December as well.

  13. Oldie May 15, 2014 at 6:35 pm #

    @Tristan: Thanks for clarification; however, if the info is taken from your 2013 T3, why would it pertain to the September quarterly distribution and not the December one. Unless you’re reading from the September distribution statement and not from the T3?

  14. Tristan May 16, 2014 at 1:56 pm #

    @Oldie: The information is from CDS Innovation’s website. The total of the quarterly distributions should appear on the T3. This is described in detail in Dan and Justin’s paper “Easy as ACB”.

  15. Michel May 19, 2014 at 1:27 pm #

    After only a week of trading, HBB now have more net assets ($ than ZDO, with 18.3M vs. 16.8M

  16. Michel May 24, 2014 at 12:25 pm #

    Well after pondering the idea quite a bit, i finally converted the fixed income position held in my registered account to HBB (from ZDB). As someone very far from retiring, i don’t have any need/desire for distributions. Yes, HBB is at risk of the CRA wrath but as CCP said, this will only mean triggering early capital gains for investors. This remote but real possibility is still better than paying tax on years and years of unwanted distributions…

    For the record, i also hold VSB in my RRSP to average down my bonds holding duration, since HBB duration is a little bit high for my taste at 7.25y. For the record, the fixed income i hold in RRSP represent about 40% of my total fixed income position.

    Regarding the use of swap ETF for equities, i personally dont use them since i prefer the much more diversified (and cheaper!) total market equivalents (think HXS vs VTI and HXT vs. VCN).

  17. Peter May 30, 2014 at 2:01 pm #

    I have to say that the bond portion of my investments is what I am struggling with the most. I have just recently taken control over my own holdings and moving to an ETF based approach. I previously had NO bonds holdings at all. 100% equities, So while getting getting the EAFE/US/Canada/Emerging equities divided is easy enough- deciding what bond fund to buy in this environment is really hard. Long term looks dead if things stay as they are and pretty grim if interest rates rise, while short term has no yield and barely keeps up with inflation.

    It will have to be in a taxable account, although this is not really much if a concern for me now. HBB, the recent BMO offering (ZAG?) and the FA 1-5 year strip bond ETF described earlier in this series hold appeal. But my timeline for retirement is only about 10 years.

    If you were starting to look at bond ETFs for the first time for a term of 10 years or less, with no need for income, would seeking the tax friendly option with shortest maturity date be the logical move for a core holding? Or is there still an argument for getting a broader ETF that simply has a good percentage if its overall holdings turning over in less than 5 or 6 years?

  18. Michel May 30, 2014 at 6:58 pm #

    @Peter have you considered mixing ZAG/HBB with VSB to attain desired duration ? This is what I do and my average duration is 4.4y

  19. Andrew June 4, 2014 at 1:38 am #

    I’ve read a lot of talk about the interest rate risk of long term bonds, and it seems to me that HBB may have potential other benefits too. If interest rate rises in the near term, then I could sell the fund and harvest the loss, and then re-buy another long term bond fund in my RRSP account. If interest rate does not rise for a while, then I benefit from the better yield of long term bonds. Seems more attractive to me than holding a long term bond fund in my RRSP right now when I have limited room.

  20. Michel June 4, 2014 at 8:40 pm #

    From what i understand, the arrival of HBB on the market also modify the usual recommendation regarding tax optimization asset allocation for taxable investor.

    Since HBB is fixed income with NO distribution, it is designed to be held in non-registered account..US domiciliated ETF (VTI/VXUS), which always lost a portion of their dividends to withholding tax, can now be held in the registered accounts (RRSP).

  21. Peter June 22, 2014 at 8:06 am #

    @Andrew @Michel I am with you on both points. Lots of benefits to HBB, and from what i can see rising interest rates would actually make the tax benefits even more pronounced. I really hate the idea of buying any bonds right now – but if I have to then HBB is the way to go. And holding them in a taxable account is while putting other higher yielding assets in my RSP is exactly what I will be doing. I will have no bond holdings in my RSP, which is a pretty strange statement to make!

  22. HeKyLl July 2, 2014 at 9:11 am #

    @Peter @Michel Great comments. IMHO, the best aspect of HBB is not in its tax benefits but in its game-changing effects on asset placement within reg’d and non-reg’d accounts. I am now sorely tempted to move all my bond holdings, with the exception of RRBs, out of my reg’d accounts. The fact that the federal gov’t may change the rules in the future gives me pause. Being forced to realize capital gains early is not good. However, my thinking is as follows: given the current environment and typically lower returns of bonds, the tax sheltering of equities should mitigate the tax consequences of a forced sale of HBB. Relying on HBB long-term may seem like a gamble but I think it’s a hedged bet.

  23. LawrenceW September 6, 2014 at 6:44 pm #

    Quick followup for my personal situation.

    I now hold my bond allocation in my non-registered account through HBB.

    My RRSP and now used to hold foreign equities.

    This setup allow me to achieve better tax-efficiency, the improvement is twofold:

    1. I don’t pay any taxes on unwanted bond distributions (thanks you HBB !)

    2. I avoid the US withholding tax the portion of my foreign equities held inside my RRSP (thanks you Canada / U.S Tax Treaty, Article XXI paragraph 2 !)


  24. ROS January 17, 2015 at 9:16 pm #

    Hi Dan,
    Would you be able to comment on the Peter’s post above, dated May 30?

  25. oldie January 17, 2015 at 9:34 pm #

    @ROS @ CCP: I would be interested in your comments, too. I note that Peter said ” But my timeline for retirement is only about 10 years” which might be ambiguous. If he means that all investment will spent around that time, then HBB, ZAG and such offerings as VAB might be marginally too long term. If he means retirement will happen in 10 years, but the whole investment will be held for a further 15 or more years, then the term of HBB and the others would be appropriate, I would think?

  26. Canadian Couch Potato January 17, 2015 at 10:32 pm #

    @ROS: I’m not sure I understand Peter’s question entirely. But if he’s asking about choosing a bond ETF for a relatively short time horizon (less than 10 years) I’ll say a few things. First, remember that if you plan to retire in 10 years, your investment horizon is much longer than that. Your portfolio needs to last until you die, not until you retire. So a broad-based bond fund could still be appropriate. If you simply prefer lower volatility in your fixed income holdings, then a short-term bond fund (typically with an average term of three years) or a GIC ladder can be an excellent alternative.

  27. Peter January 18, 2015 at 6:52 am #

    Thought I might follow up. The 10 years was until retirement, so as I have learned, the broad bond etfs are still the better choice. I still have no Bonds, but frankly the only choice I think I need to make is if I want them in a taxable account or a registered account.

  28. Rob January 27, 2015 at 1:03 pm #

    On the surface, how would a swap-based ETF differ from, say, a corporate class mutual fund outside of significantly lower fees and the previously mentioned counterparty risk?

  29. Tim August 17, 2015 at 2:21 pm #

    I see HBB seems to have taken off. When I shift my asset balance towards bonds down the road (currently bond portion fits into RRSP+TFSA) this will be a great option for taxable CCPC accounts that many small business owners use. Although already using HXS this would put a huge portion of my portfolio in swap structure.

    I wonder if they will consider starting up a shorter duration fund with a similar strategy?

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