Back in September, my colleague Justin Bender and I published a white paper entitled After-Tax Returns: How to estimate the impact of taxes on ETF performance. Justin has now updated his Excel calculator and made it available for free download on his blog.
Recently Justin put his own methodology to work by measuring the 2014 after-tax returns of 10 short-term bond ETFs. As it happens, 2014 was a relatively good year for short-term bonds: as interest rates fell again, ETFs in this asset class delivered returns between 2.3% and 3.5%. But as we have written about before, traditional fixed income ETFs tend to be full of premium bonds, which are notoriously tax-inefficient because of their high coupons. If you held one of these ETFs in a non-registered account, your after-tax return would have been lower.
Launched in 2013, the First Asset 1-5 Year Laddered Government Strip Bond (BXF) was designed to be a tax-friendly alternative. Strip bonds do not make interest payments like traditional bonds do: rather, they are sold at a discount and mature at par value. This means a strip bond is more tax-efficient than a high-coupon premium bond, because you pay tax only on an amount of interest equal to the strip bond’s yield to maturity. Even if a traditional bond ETF and a strip bond ETF enjoyed the same pre-tax return, one should expect the latter to outperform on after-tax basis.
Putting bond ETFs to the test
That’s the theory, anyway. But how would all of this play out in the real world? As Justin describes in his recent blog, BXF delivered on its promise in 2014. Not only did it produce the highest return before tax, it was more tax-efficient than all of its peers—and by a wide margin. Here are the performance numbers for 2014:
|Short-Term Bond ETF||Before-Tax Return||After-Tax Return||Tax Cost Ratio|
|First Asset 1-5 Year Laddered Government Strip Bond (BXF)||3.49%||2.76%||0.70%|
|Vanguard Canadian Short-Term Corporate Bond (VSC)||3.39%||1.84%||1.51%|
|iShares Core Canadian Short Term Corporate + Maple Bond (XSH)||3.39%||1.83%||1.51%|
|BMO Short Corporate Bond (ZCS)||3.25%||1.63%||1.57%|
|Vanguard Canadian Short-Term Bond (VSB)||2.82%||1.58%||1.21%|
|BMO Short Provincial Bond (ZPS)||3.09%||1.54%||1.50%|
|iShares Canadian Short Term Bond (XSB)||2.80%||1.48%||1.28%|
|BMO Short Federal Bond (ZFS)||2.31%||1.25%||1.03%|
|iShares 1-5 Year Laddered Corporate Bond (CBO)||3.32%||1.22%||2.03%|
|iShares 1-5 Year Laddered Government Bond (CLF)||2.94%||1.20%||1.70%|
Sources: www.canadianportfoliomanagerblog.com, CDS Innovations, BlackRock Canada, BMO Asset Management, Vanguard Investments Canada, First Asset
Justin’s methodology is explained in detail in our white paper, but it’s complicated. If you’re not prepared to wade through the details, here’s what you need to know. The before-tax returns in the table above are those published by the ETF providers themselves. These are total returns that include any increase in price during the year, as well as all distributions, which are assumed to be reinvested immediately. The after-tax return assumes that each distribution is first taxed at the highest marginal rate, and only the remaining amount is reinvested. The tax cost ratio in the far-right column offers a simple way of comparing different funds: the lower the number, the more tax-efficient the ETF.
What jumps out from this table is not only BXF’s low tax cost ratio, but also the extreme tax-inefficiency of iShares’ popular laddered bond funds, CBO and CLF. These two funds have obvious appeal for income-oriented investors: CBO has an average coupon of almost 4.8%, while CLF comes in at 3.8%. But in this era of low rates, the yield to maturity on short-term corporate and government bonds is nowhere close to that—in fact, for CLF it’s now well under 1%. That means unless rates keep falling, investors in these ETFs should expect hefty payouts but also a significant decline in price. If interest remain unchanged, both funds could easily deliver negative after-tax returns despite their high yields.
My guess is that many investors (and their advisors) are unaware of this danger. CBO has more than $2.2 billion in assets, making it the fourth-largest ETF in Canada, and CLF is in the top 20 with almost a billion. Surely not all of those shares are being held in RRSPs and TFSAs. Meanwhile, BXF has attracted just $18 million despite its inherently more tax-friendly structure. Another example of how juicy yields can seduce investors into making poor decisions.
How’s your brokerage?
This year MoneySense and the research firm Surviscor are again teaming up to review Canada’s top discount brokerages. (I wrote the first two editions of this feature, the most recent of which is available here.) The magazine is looking for DIY investors who are willing to share their online brokerage experiences—positive or negative—for this article.