Barry Gordon admits he was surprised when he first read Justin Bender’s entry in First Asset’s Search for Canada’s Next Top ETF contest, which I introduced in my previous post. “It runs against the grain of everything we thought we knew about strip bonds,” he says. But Gordon’s firm turned the idea into the First Asset DEX 1-5 Year Laddered Government Strip Bond Index ETF (BXF), which begins trading next Tuesday. Here’s an overview of this innovative new index fund, as well as an explanation of how it might be used in a portfolio.

Inside the ETF

First Asset tasked PC-Bond with creating the index for their new strip bond ETF. Here’s the basic methodology:

  • the ladder will have “term buckets” with bonds of approximately one, two, three, four and five years to maturity
  • each bucket will include five individual strip bonds: four provincial (mostly issued by Ontario and Quebec) and one federal (or federal agency)
  • the bonds will be selected with liquidity in mind: the issues must be at least $50 million and will be screened for maximum trading volume
  • the index will rebalance annually in June: bonds with less than one year to maturity will be sold and the proceeds used to purchase new bonds for the five-year bucket

No surprises so far. But you’ll recall that one of the key characteristics of strip bonds—and the main reason why conventional wisdom says you should not hold them in taxable accounts—is they don’t generate any income. That’s where this ETF is different: it will make quarterly distributions based on the fund’s average yield to maturity, which is expected to be about 1.6%. That means investors can expect a quarterly payout of about $40 on every $10,000 invested.

Where are these distributions coming from if the holdings don’t actually pay interest? Gordon explains that “for the foreseeable future we’ll hold sufficient cash” to fund the payouts. The drag from this uninvested cash should be trivial, since the amounts are so small.

The cost of the new ETF is also a pleasant surprise. First Asset is offering a fee holiday for the first 12 months: that means a 0% MER until July 2014, after which the management fee will be a modest 0.20%.

A premium problem

Justin’s eureka moment came while working with a client who has a seven-figure fixed-income portfolio, mostly in non-registered accounts. GICs are usually the best vehicle for investors in this situation, but they have a few limitations. First, wealthy investors may find it difficult to stay within the CDIC limit of $100,000 per issuer, especially if their brokerage offers a limited menu. The second problem—more relevant to those of us unburdened by millions of dollars—is that they’re illiquid. Because you can’t sell them before maturity (unless you’re using cashable GICs), they’re not helpful if you want to rebalance your portfolio after a downturn in the equity markets.

In theory, a short-term government bond ETF would solve both these problems, but traditional bond ETFs are terribly tax-inefficient. The reason is that virtually all bonds now trade at a premium: they were issued when interest rates were higher, so they’re priced above face value. That’s a bad combination for taxable investors, because it means you pay tax on a high coupon and then get stuck with a capital loss when the bond matures.

An example: the iShares 1-5 Year Laddered Government Bond (CLF) would have provided similar credit risk and better liquidity than a GIC ladder, but Justin’s analysis showed it would have a negative after-tax return. CLF pays out about 4.2% in fully taxable interest, and since its yield to maturity is just 1.4%, you can expect it to suffer a significant capital loss every year.

There must be hundreds of millions invested in this tax-inefficient manner. CLF has more than $1 billion in assets, and the iShares DEX Short Term Bond (XSB) is the second-largest ETF in the country with more than $2.2 billion. Surely not all of that is held in registered accounts, which must be making the Canada Revenue Agency dance a little jig.

More tax-friendly than you think

Faced with this problem, Justin thought of strip bonds, which always trade at a discount. With strips you pay tax only on an amount equal to the yield to maturity, not on an inflated coupon. And you won’t suffer a capital loss unless interest rates spike and the bond is sold before maturity.

These tax advantages are overlooked by folks who say strip bonds should never be held in a non-registered account. It’s true they don’t generate income, but if you weren’t planning to spend the interest payments, that’s irrelevant. In any case, First Asset’s new ETF is structured to pay distributions, so you end up with the best of both worlds: tax-efficiency and cash flow.

To sum up, BXF is designed for non-registered accounts where the investor wants a fixed-income product combining the tax-efficiency of GICs and the liquidity and security of government bonds.

The only trade-off is that strip bonds have a longer duration than traditional bonds of the same maturity, so BXF (with a duration of about 3.6) will be somewhat more sensitive to interest rate movements than CLF (duration 2.5) and XSB (duration 2.8). That means a little more volatility, but if the idea is take advantage of rebalancing opportunities, that’s not necessarily a bad thing.

A strip bond ETF is a useful and innovative product, I’d say. Makes you wonder why no one thought of it before.