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.
I currently hold XBB in my professional corporate account. I’ve read your and Justin’s articles regarding why it’s not tax-efficient to hold ETF bonds in non-registered account/corporate accounts, and I was about to switch over to GICs. However, after showing these articles to my accountant and financial advisor friend, they both separately stated that in my situation where I am buying and holding XBB for the long-term (>20 years) with no intention of selling the ETF, then I don’t need to worry about this issue – It’s only when/if I sell the ETF bond, then your reasons may apply depending on the current market/par value. I rebalance by adding fresh money into the account, and hold a significant cash position, so that I do not foresee myself ever selling XBB to rebalance. Is this correct thinking or is my accountant misinterpreting your articles? Thanks in advance!
I’m not sure about this:
“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.”
Disagree with the double whammy part. Isn’t a capital loss a good thing from a tax perspective, since it prevents you from paying when you have capital gains? I agree that discount bonds are tax advantaged, but the reason is because interest is fully taxed whereas capital gains are taxed at 50%.
Very interesting.
In a non-registered account, would ZDB be more tax efficient than a GIC ladder?
With regards to long-term investors, could you also say a few words about the ‘coupon’ vs. ‘yield to maturity’ rates during times of rising interest rates?
Very informative post! Your blog is the best at keeping us up to date on new and relevant ETFs.
One question about ZDB
Over time, the discount bonds it buys could become premium bonds if interest rates go down from the time the bonds were bought by the fund.
If I buy ZDB after a period of this happening, am I buying a bond fund that now has a lot of premium bonds? Or do they do something that mitigates this from happening?
What effect would this have on a person’s returns. They could be buying a bond fund that has a lot of built up capital gains, but they may have bought it at a higher price.
Could a person end up with a capital gain from these premium bonds, but not benefit from it because they bought the fund after the bonds became premium bonds? Could this sort of situation have a negative tax effect. I get paid a capital gain that I have not been in the fund long enough to earn, so I end up paying tax on a gain I did not really get?
I think some mutual funds can cause this problem. If a mutual fund realizes a long-term capital gain near the beginning of the year, but does not pay out the gain until later in the year, and a person buys the fund just before it pays out, they could end up paying tax on a gain they did not really have.
Could ZDB have this issue?
Sounds like the Holy Grail I have been searching for in my retirement non-registered account: No need switching out of investment account to a HISA, no need for complicated and clumsy GIC ladder, convenient and relatively tax-efficient bond performance, and handy ample source of relatively stable cash conversion for rebalancing if/when equities fall.
Any catches? (The potential adding of premium question that @Jim raises is interesting). How would the laddered, stripped BXF described in https://canadiancouchpotato.com/2013/06/07/why-use-a-strip-bond-etf/
compare for the job relative to ZDB?
@CCP: ZEA certainly is a sleeper — the actual holding of underlying stocks is a huge advantage when you look closer. I likely will switch my US based EAFE holdings to ZEA (I am getting nervous about the way the US Estate Duty regulations are heading).
I know you think you don’t have clairvoyance — you’ve been protesting that for years :) , but do you think that this might signal a possible preparation for launching a similar unhedged Emerging Markets Index Z-fund? Or even (dare I hope it) split Europe and Pacific Rim Funds?
another great post. Could you please explain what the end of the day difference would be between ZDB and BXF? Why would you choose one over the other?
If I understand well ZEA, underlying stocks directly, rather than holding a US-listed ETF the advantage will be that we don’t have to pay withholding tax to the US but sill have to pay them for the country that have no tax treaty with Canada for the RRSP.
Great news! I wonder what would be the difference in terms of tax efficiency between ZDB, ZAG, BXF and GICS. Would ZDB be the most tax efficient option for a taxable account?
Related to Adam’s post:
Looking at XBB’s distribution history and its 2012 annual report (http://ca.ishares.com/content/stream.jsp?url=/content/en_ca/repository/resource/annual_report/annual_report_2012_en.pdf), I don’t see a history of distributing capital losses. It doesn’t even have any carry-forward capital losses at the end of 2012 (note 10, page 217).
So, for a long-term XBB holder in a taxable account, is it really so important to hold a tax-efficient bond fund, instead?
@Adam: I don’t want to contradict any experts you consulted, because I don’t know your whole situation. But holding a fund full of premium bonds is tax-inefficient even if you are holding for the long term for the simple reason that the high coupons are taxable in the year they are received.
@Adam C: A capital loss may have a silver lining in that in can be used to offset a gain incurred elsewhere. But I cannot think of any situation where you are better off holding an investment that creates capital losses rather than capital gains. It’s a bit like saying you’re happy your employer forgot to pay you this week, because now your tax bill will be lower.
@Mike: Yes, in theory a discount bond could be more tax-efficient than a GIC. It would be better to get 1% interest and a 2% capital gain than 3% interest. But keep in mind that GICs tend to have higher interest payments than comparable bonds, so the “all other things being equal” qualifier applies here.
@Frank: If interest rates rise, then as bond funds gradually replace their holdings you will see the gap between the coupon and the yield to maturity get smaller.
@Jim, sleepydoc, John and others: The fund is brand new and I don’t know how it will be managed. BXF is also very new and it’s just not clear (at least not to me) how all of the possible scenarios could play out. It wouldn’t be responsible for me to speculate about how their performance or tax treatments might differ.
@ccpfan: Investment funds don’t distribute capital losses. They can only distribute capital gains, and if possible, use capital losses to offset these. The capital losses I’m referring to in regards to bond ETFs are the price declines that inevitably occur if the fund holds premium bonds and interest rates do not fall. It’s true you have some control over when to realize these losses, but (as I write to Adam C above) a steady decline in the price of a fund can’t be viewed as good thing unless it is offset by interest payments, as it is in a registered account. So, yes, traditional bond funds are a poor choice in a taxable account regardless of your holding period.
Hi, when a discount bond matures or is sold, would a fund have to distribute the resulting capital gain the same year, or would we see only see the price/NAV of the ETF increase?
Thanks.
@Tyler: If the fund realizes a capital gain it should distribute it to unitholders. But capital gains distributions can be unpredictable, since ETFs have ways of offsetting those gains and avoiding passing them along to investors. Again, this is one of those questions where the only answer is “we won’t know for sure until the fund has some history.”
According to BMO’s website, 99.69% of the holdings for ZEA is “iShares MSCI EAFE ETF”. Do you know something we don’t about it holding underlying securities directly?
http://www.etfs.bmo.com/bmo-etfs/holdings?fundId=97630
@CCP:
With ZSP and ZEA, can you receive real capital gain distributions from the ETF, unlike US-listed ETFs, which will be correctly taxed as capital gains and not foreign income?
Interesting structure with no foreign taxes withheld. That might make more sense for some investors. Looking forward to the cost comparison next week
@SS: That is almost certainly a temporary arrangement. My contact at BMO explained the portfolio of ZEA will be the same as ZDM, which holds the stocks directly.
@Jas: Any capital gains incurred within ZSP should be passed along to unitholders as capital gains, not as foreign income. If in doubt, contact BMO directly. This is good advice for all investors who are interested in the specific tax treatment of any ETF: I cannot predict how any fund will make distributions.
Hi CCP, is there any reason more bonds don’t eliminate the interest component and just pay out in capital gains? Wouldn’t investors be much more enthusiastic about this kind of product?
@CCP: Bond issuers cannot elect to “pay out in capital gains.” If it’s a bond, it pays interest, by definition. Even a strip bond, which does not pay any coupon but is simple sold at a discount to par value, is still taxed as interest.
One other question, if I may double-check my understanding: yield to maturity does not include the effect of an ETF’s MER, right? Thanks.
@Tyler: That’s right, the published YTM does not include the fund’s fees.
Thanks for your reply Dan. I should’ve clarified my question/situation – when one’s portfolio is predominantly in a non-registered/corporate account, and thus has to hold fixed income due to one’s asset allocation, is there really any difference to holding XBB vs. GIC for the long term (>20 yrs with no intention to sell XBB for rebalancing), since both will simply spit out interest income which are taxed similarily (both taxed inefficiently)?
Thanks again,
Adam
Related to Adam’s post:
If you had to hold XBB or VAB in your non-registered or corporate account for the long term, b/c of lack of room in your registered account (i think quite a few medical professionals are in this situation), then I think it shouldn’t matter whether you use XBB/VAB vs. GICs, since they are both equally taxed inefficiently as interest income during that year. The unit cost will fluctuate more with an ETF bond, but I don’t think it matter in the long term.
@Heparin: It does matter because what’s left after you’ve paid taxes on the higher coupons of the premium bonds is not enough to make up for the declining price of the bond fund (assuming interest rates don’t change) due to capital losses from the premium bonds, such that you would be at least equal to after tax returns from a GIC ladder. Therefore your after tax return is better from GIC’s than bond funds in taxable accounts. Dan, please correct me if that explanation is not accurate.
@Adam and Heparin: I think the key point you’re missing is that premium bonds (by definition) have higher coupons than bonds (or GICs) purchased at par. So they are going to be paying out more interest, and therefore you will pay more tax every year. That would be fine if it was the end of the story: I would rather get a 5% coupon than a 3% coupon if both were taxed equally. But it’s only half the story, because the premium bond will then mature or be sold at a loss, while the par bond or GIC will not suffer this loss.
I’m not sure how else to explain it, but the answer is clear: premium bonds (and ETFs that hold them) are less tax-efficient than GICs, no matter what your holding period is.
@CCP:
So if I understand ZDB and BXZ are two different answers to the same problem with traditional bond ETF held inside taxable accounts? Are they complementary inside one’s taxable portfolio?
With regard to ZEA, if you go to BMO’s website, and look at ZEA’s holdings, it’ll show that the major holding is “iShares MSCI EAFE ETF”, or EFA. So I don’t know why you’d say it holds the underlying foreign stocks directly, it seems ZEA just holds US-listed foreign ETF.
@Jas: Yes, I would agree that the two ETFs are different answers to the same problem. I don’t think anyone can say which is better at this point: there’s just not enough information on which to base the decision.
@David L: See my comment to SS above.
Unlike most new ETF launches, I think kudos are in order for the people at BMO for filling a real market need with this one.
Will ZDB drop in price with rising interest rates, ie suffer capital loss, as has happened with XBB and ZRE when interest rates went up early last year? Is ZDB a better choice than short-term bond ETFs (or laddered GICs/bonds) to mitigate capital losses in a rising-interest-rate environment?
CCP: Thanks for the details regarding that eventually ZEA should hold underlying securities. I assume it needs to grow to a certain size before that is feasible.
I do note that they say they may hold ETFs in their Portfolio Strategy.
“The Manager may use a sampling methodology in selecting investments for the fund. The Fund may also invest in or hold securities intended to replicate the performance of the Index. In addition, as ZEA may hold other underlying ETFs, the management fees charged are reduced by the management fees paid on the underlying ETFs.”
Do any of you remember back in the day…..maybe the late 80’s or early 90’s when you could get a step-rate GIC for 4,6,8,10 and 12 % if you held it for 5 years. I’m sure we all wish for those % yields again but atleast some of these newer products are being a bit more innovative, maybe while we wait for these rates again. LOL
Hi Dan,
Would you recommend ZEA over XEF in a TFSA and would ZEA replace XEF in your recommended portfolios?
Sue, don’t forget that the inflation rate in 1980, 1981 and 1982 was over 10% each year vs. just over 1% in 2013. So, in real terms (after inflation) a step rate GIC in those days would have been -6%, -4%, -2%, 0%, 2% or an average of -2%! That makes today’s 5yr GIC at 3% nominal or 2% real return seem like a bargain. :)
Brian G, well said. Much worse after taxes too.
Thanks Brian for your reply. I must admit I was a high schooler back then with my step rated GIC so maybe my parents felt the rates of inflation and likely their mortgage rate more so than I would have known about. Fast forward to now…..I pay attention!!! :)
BMO has launched new bond ETFs recently and the list of available choices is getting bigger. It is getting harder for average investors to decide which one is more suitable for them (ZAG, ZDB, ….) Can you have a educational post on different types of bond ETFs and the difference between the underlying indices?
How’s ZEA different from Vanguard’s VDU ? To the best of my knowledge, VDU owns the shares as opposed to owning shares of VXUS.
@Behzad, this article does tell the difference between ZAG and ZDB… both are basically the same (broad market medium term bond indexes) except ZDB is more tax efficient when held in a taxable account. If you are holding the fund in a RSP or TFSA, then any old regular broad market bond index fund is fine.
@Linda, I can’t see any big difference. What I can see is that BMO uses the MSCI index and Vanguard use the FTSE index which is likely to make no practical difference. Strangely, right now BMO is just a wrapper around a US iShares ETF like Vanguard holds it’s US ETF but like previous comments state, BMO is likely to change that as assets under management grow to make it feasible to hold individual stocks. Until them, there is no real difference that I can see.
@Linda:
as explained on vanguard website VDU “invests primarily in the U.S.-domiciled Vanguard FTSE Developed Markets ETF”
@SS: That description of ZEA is pretty much boilerplate: almost all index funds reserve the right to say they can use representative sampling or hold underlying ETFs. Most never do so, though ZDM (the hedged version of BMO’s international equity ETF) actually does use sampling and keeps a small percentage of its holdings in an underlying ETF. I would expect ZEA and ZDM to eventually have virtually identical holdings, with the only difference being the hedging.
@Saad: It’s much too early to be recommending this ETF specifically. In theory, yes, ZEA should be more tax-efficient than XEF in a registered account.
@Behzad: Try not to get overwhelmed by ETF choices. For most investors, the most significant choice is whether to use a broad-based bond fund or a short-term bond fund. If you have a long time horizon, a fairly small allocation to bonds, and a willingness to tolerate a bit of volatility, a broad-based fund is likely to be suitable. This would include ZAG, VAB or XBB. If you have a shorter time horizon or less tolerance for volatility, a short-term fund is likely to be more appropriate. This would include VSB and XSB, as well as a couple of more specific offerings from BMO.
ZDB is appropriate only for taxable accounts, and many investors will never get to the stage where they have to keep fixed income in taxable accounts.
@Linda: As others have noted, VDU and ZEA have very similar strategies, but VDU does not hold its stocks directly. Its underlying holding is the Vanguard FTSE Developed Markets ETF (VEA).
Regarding VDU, it is strange that they say that it “Invests primarily in the U.S.-domiciled Vanguard FTSE Developed Markets ETF.” while at the bottom of the page, they say “For any Vanguard ETF (VUS, VEE, VEF, VSP and VFV) that primarily invests in an underlying US domiciled Vanguard fund, the information displayed belongs to the corresponding US domiciled Vanguard fund. ” and as you can see, VDU is not listed among those investing primarily in the US-counterpart ETF.
@Linda: I agree Vanguard Canada could be clearer about this. In fact, all of their US and international ETFs hold underlying US-listed ETFs without exception.
I hope BMO and other ETF providers will continue to release more tax efficient ETFs for those who have to invest in a taxable account. I don’t know if it’s feasible but perhaps a short term discount bond etf would also be useful and swap based ETFs to compete with Horizons.
In considering the relative risk/reward of ZDB and BXF, should consideration be given to differences between them in roll yield? Specifically, I’m guessing that BXF will generate more roll yield than ZDB (assuming the curve remains positively sloped), and if this guess is right then BXFs YTM understates total expected return when the curve is positively sloped and overstates it during the brief periods when the curve is negatively sloped. But I’m just not sure how to factor roll yield into my thinking.
@CCP:
Dan, the observation that “many investors will never get to the stage where they have to keep fixed income in taxable accounts” is not necessarily true for newcomers to Canada. I would argue that most of these need to keep the vast majority of their investable assets in taxable accounts while contribution room in registered accounts slowly grows over the years.
For this group of investors ZDB is very appropriate indeed.
You said: “@Adam C: A capital loss may have a silver lining in that in can be used to offset a gain incurred elsewhere. But I cannot think of any situation where you are better off holding an investment that creates capital losses rather than capital gains. It’s a bit like saying you’re happy your employer forgot to pay you this week, because now your tax bill will be lower.”
I didn’t say that you’re better off holding an investment that creates capital losses. I agree with you that discount bonds are tax advantaged, just not on the “double whammy” part in regards to the capital loss.
Let me give you an example. Say you have Bond A and Bond B, both mature in one year and pay their one and only coupon at maturity. Bond A gives 0% interest, trades at $98, effective return is about 2%. Bond B gives 100% interest but trades at $196, again effective return about 2%.
From a total return perspective (ignoring taxes), the total returns are roughly the same, about 2%.
From an interest tax perspective, Bond A is superior because you pay $0, which is $100*(full marginal tax rate) less than Bond B. From a capital gains tax perspective, Bond B is superior because you can write off other capital gains on your massive loss, effectively saving you 50% of your marginal tax rate on $96 as opposed to Bond A which adds to your capital gains.
When you put these two (competing) factors together, Bond A is superior from a tax perspective, period. But they ARE competing factors, as opposed to a “double whammy” which is the only point I was trying to make.
Why not buy bonds directly from your broker, especially discount bonds, rather than buying an ETF. I know fees are cheaper on ETFs but the MER of a bond is 0.00% although you are likely paying a much higher bid-ask spread than an institutional asset manager like BMO or Blackrock. Isn’t this the best solution for many ivestors?
Determine what term/duration you want and whether you care about when the coupons are paid (do you want coupon cash flow every month of the calendar or does that not matter) and buy a bunch of bonds, assuming that you want fixed income exposure.
For folks that have a DB pension plan then you might not need as much Fixed Income exposure in your portfolio since that DB plan acts very much like Fixed Income.
@Zaphod: Buying individual bonds is not unreasonable: in theory it’s very similar to buying GICs. But most specialists would tell you that bond markups are terrible for individual investors, especially if you buy them through discount brokerages. And if you are buying corporate bonds, you are taking on credit risk by having significant holdings in individual issues. I think you will also find the selection of discount bonds available is extremely small.
https://canadiancouchpotato.com/2010/03/29/bonds-v-bond-funds/