Everyone loves a discount, but if you’re buying bonds these days you may be out of luck.

Just over a year ago, the BMO Discount Bond (ZDB) was launched as a tax-efficient alternative to traditional bond ETFs. ZDB tracks the broad Canadian market, but it selects bonds trading at a discount, or at a very small premium. Discount bonds have a lower coupon than comparable new bonds, and they will mature with a small capital gain. That combination is more tax-efficient than premium bonds, which have higher coupons and mature at a loss.

A discount bond ETF is a great idea for non-registered accounts, but it faced challenges from the beginning. After many years of interest rates trending downward, there simply aren’t many discount bonds in the marketplace. Traditional broad-market bond ETFs hold between 500 and 900 issues, but ZDB holds just 55.

This constraint has become more urgent after the Bank of Canada unexpectedly cut short-term rates in January. Yields on intermediate and longer-term bonds also fell, driving bond prices up sharply. Suddenly bonds that were trading at a discount were priced at or above par.

In my blog post introducing ZDB, I explained that there’s an easy way to tell if the bonds in an ETF are trading at a premium: just visit its website and compare the fund’s average coupon to its yield to maturity. If the average coupon is higher, then most of the bonds in the ETF are trading at a premium. ZDB’s distinguishing feature when it was launched was that its coupon was significantly lower than its yield to maturity. But that’s no longer the case:


A good trade-off

I recently spoke with my contacts at BMO about this predicament, and they confirmed it is becoming increasingly difficult to find new discount bonds. That means the managers of ZDB will face some big decisions when the fund’s next rebalancing date arrives in April.

They could relax the constraints and buy bonds that trade at slightly higher premiums. ZDB’s benchmark, the FTSE TMX Canada Universe Discount Bond Index, includes only bonds with a price of $100.50 (that’s 0.5% above par), but the fund managers could choose to buy bonds up to $101, for example. That wouldn’t cause much tracking error, because performance is always measured on a before-tax basis. But, of course, it would make the ETF less tax-efficient.

When you consider the trade-offs, adding more premium bonds is probably the right decision. The alternative would be to slavishly follow the index, and that would leave ZDB holding even fewer bonds than it does now. Risk management always needs to come before reducing taxes, so if better diversification comes at the cost of slighter higher taxes, then that’s the way it has to be.

Going forward, I expect BMO will have a discussion with FTSE about making some changes to the index. This is always controversial, because no one wants to change the rules in the middle of the game. But an index benchmark has to be investable in the real world, and in this case it’s the market that changed the rules.

The tax benefit is still there

While it will be interesting to watch ZDB evolve, let’s not lose sight of the fact that it should always be expected to outperform traditional bond ETFs on an after-tax basis.

Consider the BMO Aggregate Bond (ZAG), which should behave very similarly to ZDB on a before-tax basis. (As of March 6, their 12-month returns were almost identical, according to Morningstar.) This traditional broad-market ETF has a yield to maturity of 1.67%, only slightly more than ZDB’s. But its coupon is much higher at 3.85%, which means more of ZAG’s return will be lost to taxes.

Even if ZDB isn’t truly a discount bond ETF anymore, its relative tax benefit is still there. It’s still a good choice for investors who want broad-market bond exposure in non-registered accounts.