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.