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The Curious Case of the BMO Discount Bond ETF

2018-05-29T22:02:27+00:00March 1st, 2016|Categories: Bonds, ETFs, Indexes, Taxes|Tags: , , |32 Comments

When the BMO Discount Bond Index ETF (ZDB) was launched back in February 2014, it was unique: the first broad-market ETF in Canada made up primarily of bonds trading below their par value. By avoiding premium bonds, ZDB promised to deliver similar returns to traditional bond funds, but with greater tax efficiency, making it ideal for non-registered accounts. With a little more than two years of real-word performance, it’s time for a checkup. Has ZDB delivered on its promises?

Top of the heap

The first question we’ll examine is whether ZDB achieved pre-tax returns similar to other broad-market bond ETFs. The fund was designed to match the popular FTSE TMX Canada Universe Bond Index in credit quality, average term, duration and yield to maturity. But ZDB set out to achieve this profile using bonds with lower coupons to reduce the amount of taxable income.

As it turns out, ZDB outperformed all of its competitors in 2015. Here are the NAV returns for the calendar year:

BMO Discount Bond ZDB 3.60%
Vanguard Canadian Aggregate Bond VAB 3.48%
iShares Core High Quality Canadian Bond XQB 3.38%
BMO Aggregate Bond ZAG 3.24%
iShares Canadian Universe Bond XBB 3.15%
Sources:  BMO ETFs, BlackRock, Vanguard Canada, Morningstar

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If you own ZDB you would have been pleased with that 3.60% return, but you should be curious about why the fund managed to finish ahead of its counterparts. And you’ll really be scratching your head when you learn that the FTSE TMX Canada Universe Discount Bond Index returned just 2.18% on the year. An index fund typically lags its benchmark by an amount roughly equal to its fee, so it’s unusual to see any outperformance at all, let alone 142 basis points. What’s going on?

The other side of the track

I contacted BMO for an answer, and they explained that falling rates in early 2015 made discount bonds extremely hard to find. As a result, the index (which was custom-designed for ZDB) became highly restrictive. Had the fund managers followed its rules slavishly, the fund would have been too concentrated in a small number of issuers. Moreover, its yield to maturity would have fallen well below that of the broad market. So the managers decided to include bonds outside the index in an effort to more closely match the characteristics of the much-followed FTSE TMX Canada Universe Bond Index while still keeping the bonds’ coupons as low as possible.

This kind of sampling can be expected to cause some tracking error, and in 2015 that turned out to be positive: even after fees, ZDB returned a little more than the Universe index, which delivered 3.52% on the year.

Were the managers right to ignore their own benchmark like this? Certainly it’s an unorthodox move for an index fund which, by definition, is supposed to follow a set of predetermined rules. And while it worked out last year, future tracking errors could easily be negative. But I think BMO made the right call here.

After all, investors who use ZDB expect it to deliver pre-tax returns in line with traditional broad-market bond ETFs, and last year that was about 3.5% before fees. Had the managers tracked their custom benchmark precisely and delivered about 2%, I’m not sure investors would have been pleased with that result. So BMO’s decision followed the spirit of the law, if not the letter.

I wouldn’t be surprised if BMO eventually changed the mandate of ZDB, dropping the custom index altogether and explicitly aiming to track the FTSE TMX Canada Universe Bond Index while keeping the fund’s average coupon as low as possible. That’s effectively what they’re doing now anyway.

How much did you keep?

OK, now let’s see how ZDB stacked up in terms of tax-efficiency. To answer this question, we turn to Justin Bender’s analysis, posted last week on his Canadian Portfolio Manager blog.

Justin has developed a methodology for estimating the after-tax returns on Canadian ETFs, which we introduced in a white paper back in 2014. In simple terms, we assume that all distributions from the ETF are taxed at the highest rate, and that that the remainder is reinvested in the fund. We then compare this after-tax return to the published pre-tax return and calculate the ETF’s tax cost ratio, which estimates the amount lost to taxes. The lower the number, the more tax-efficient the fund.

ZDB excelled here as well. If you held the ETF throughout 2015 and were taxed at the highest rate, you would still have kept more than two-thirds of the fund’s 3.60% pre-tax return. Meanwhile, the least tax-efficient bond funds in this group (ZAG and XBB) saw their returns reduced by more than half:

After-tax return Tax cost ratio
BMO Discount Bond ZDB 2.52% 1.04%
iShares Core High Quality Cdn Bond XQB 1.87% 1.46%
Vanguard Canadian Aggregate Bond VAB 1.91% 1.51%
BMO Aggregate Bond ZAG 1.61% 1.58%
iShares Canadian Universe Bond XBB 1.39% 1.70%
Source: Justin Bender, Canadian Portfolio Manager

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But is it well diversified?

So we’ve established that the BMO Discount Bond Index ETF performed very well on both a pre-tax and after-tax basis in 2015. But did those higher returns come with greater risk?

One of the criticisms we’ve heard levelled at ZDB is that it is poorly diversified. After all, it holds just 77 bonds: by comparison, ZAG and VAB hold between 650 and 700, while XBB holds close to 1,000. One might conclude that these counterparts carry far less risk. But is that true?

First, remember that about 70% of ZDB is made up of government bonds, and the breakdown among federal and provincial issues is extremely similar to that of ZAG. Both funds therefore have virtually identical risk exposure on the government side, even though the latter holds hundreds of additional bonds. (Holding 100 Government of Canada bonds, after all, is no less risky than holding only 10 or 20.)

Among the remaining 30% that is invested in corporate bonds, ZDB’s holdings are indeed more concentrated, with significant holdings in only a small number of companies, including TELUS, Toyota, and several banks. To quantify this risk, Justin used a metric called the diversity index. This formula (based on a concept borrowed from ecology) produces a value for any portfolio based not only on the number of bonds, but also on the dollar amounts in each issuer. A portfolio with a diversity index value of 100, for example, would have only one-fifth the concentration risk of one with a value of 20.

When Justin compared the corporate holdings of the two BMO funds, he found that ZDB had a diversity index value of about 16.7, compared with 45.4 for ZAG. That’s a significant difference. But overall—when you consider the government and corporate holdings together—the diversity index values were 8.5 for ZDB and 8.9 for ZAG, a much more modest gap.

Overall, then, it seems safe to conclude that BMO Discount Bond Index ETF has performed as advertised. For investors who want broad-market bond exposure in a non-registered account, ZDB is an excellent way to get it.

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The two-day event will feature more than 25 speakers, including The Globe and Mail‘s Rob Carrick and PWL Capital’s director of research, Raymond Kerzérho.