Bonds are one of the least tax-friendly asset classes: most of their return comes from interest payments, which are taxed at the highest rate. They’re even less tax-efficient when their market price is higher than their par value: these premium bonds are taxed so unfavorably they can actually deliver a negative after-tax return. Unfortunately, because interest rates have trended down for three decades, virtually every bond index fund and ETF is filled with premium bonds. Enter the BMO Discount Bond ETF (ZDB), which begins trading tomorrow. This unique new ETF promises to eliminate the problem that has long plagued bond funds in non-registered accounts.

Let’s take a step back and review the important idea underpinning this new ETF. Consider a premium bond with a coupon of 5% and a yield to maturity of 3%. The bond will pay you 5% interest annually and then suffer a capital loss of 2% at maturity, for a total pre-tax return of 3%. Now consider a discount bond that pays a coupon of 2% and has the same yield to maturity of 3%: now, in addition to the interest payments, you’d net a 1% capital gain at maturity, and your total pre-tax return would again be 3%. In an RRSP or TFSA, therefore, these two bonds would be virtually identical.

But not so in a taxable account: the investor holding the premium bond would be fully taxed on the 5% interest payments and would suffer a capital loss—a double whammy. Meanwhile the holder of the discount bond would be fully taxed on just 2% in interest, and then taxed on only half the 1% capital gain. As a result, the discount bond holder would have a significantly higher after-tax return.

There are a couple of ways to hold fixed income in a non-registered account while avoiding premium bonds. One is to use GICs instead of bond funds: GICs always trade at par, so they have lower interest payments and never suffer capital losses. Another is to use strip bonds, which always trade at a discount to par value. Last year saw the launch of the First Asset DEX 1-5 Year Laddered Government Strip Bond Index ETF (BXF), inspired by Justin Bender’s search for a tax-efficient fixed-income ETF. Now BMO has entered the arena with the first ETF designed to  give taxable investors exposure to the broad Canadian bond market, but with a portfolio that consists only of tax-friendly discount bonds.

Zigging along with ZAG

The new ETF will have characteristics very similar to the BMO Aggregate Bond Index ETF (ZAG), which could be a core bond holding in any balanced portfolio. The two funds will be very similar in average term to maturity, duration, credit quality, yield to maturity and management fee (0.20%). The key difference, however, will be that ZDB’s average coupon will be lower that its yield to maturity, resulting in much greater tax-efficiency:

According to BMO, the new fund will hold about 50 issues when it launches, and as the ETF gathers assets it will build to more than 70 bonds. By comparison, traditional broad-based bond index funds include hundreds of holdings, but remember, there just aren’t that many discount bonds available in the marketplace. A portfolio of 50 to 70 is more than enough to provide adequate diversification.