The recent rate cut by the Bank of Canada has continued to push bond yields lower. The yield-to-maturity on the iShares Canadian Universe Bond Index ETF (XBB) has dropped from 2.22% to 1.70% since the beginning of 2015 (this figure is as of January 28, 2015, and before fees and taxes). Due to the tax-inefficient nature of most bond ETFs, the after-tax returns for these products are expected to be considerably lower when held in taxable accounts.
Canadian ETF providers have been busy releasing more tax-efficient bond ETFs to mitigate this problem. The Horizons CDN Select Universe Bond ETF (HBB) is one such product. This ETF uses a total-return swap structure, which effectively converts the interest payments (which are taxed at the investor’s marginal tax rate), into deferred capital gains (which are taxed at only half the investor’s marginal tax rate, and only when the ETF is ultimately sold). Due to this advantage, HBB would be expected to have higher after-tax returns than a traditional bond ETF, like XBB.
While the tax benefits of HBB sound enticing, this ETF will likely shine more when bond yields are much higher than they are today. With current interest rates as low as they are, a GIC strategy might be expected to generate similar after-tax returns to HBB without the added complexity.
To illustrate what I mean, let’s compare two scenarios – one taxable investor who allocates $100,000 to HBB, and another investor who allocates $100,000 to GICs. Both investors are assumed to have a marginal tax rate of 50% (the highest in Canada). The yields are expected to remain constant throughout the holding period.
Scenario 1: Invest $100,000 in HBB
In this example, the investor would have an expected before-tax return of 1.38% (1.70% yield-to-maturity – 0.17% MER – 0.15% swap fee). The expected return is in the form of deferred capital gains (which are taxed at half the investor’s 50% marginal tax rate on liquidation of the ETF). I have assumed all the growth is reinvested each year. However, I’ve included a fourth column, Market Value Post-Liquidation, which shows the effect of an investor who sells the ETF at the end of any given year over the time horizon.
Over a 10-year holding period, the market value of the ETF would be expected to grow to $114,695 before-tax. The capital gain realized on the sale would be $14,695, at which time half would be taxable at 50%. The taxes payable would be $3,674 ($14,695 × ½ × 50%), resulting in a post-liquidation value of $111,021 ($114,695 – $3,674).
After-Tax Expected Return of HBB
| Year | Market Value Beginning | Market Value Ending | Market Value Post-Liquidation |
| 1 | $100,000 | $101,381 | $101,035 |
| 2 | $101,381 | $102,780 | $102,085 |
| 3 | $102,780 | $104,199 | $103,149 |
| 4 | $104,199 | $105,637 | $104,228 |
| 5 | $105,637 | $107,096 | $105,322 |
| 6 | $107,096 | $108,574 | $106,431 |
| 7 | $108,574 | $110,073 | $107,555 |
| 8 | $110,073 | $111,593 | $108,694 |
| 9 | $111,593 | $113,133 | $109,850 |
| 10 | $113,133 | $114,695 | $111,021 |
Source: Justin Bender
Scenario 2: Invest $100,000 in a GIC
The other investor prefers to keep it simple, and instead invests $100,000 in a boring 5-year GIC paying 2.15% interest annually (this was the highest rate available through our brokerage at the time of writing). The interest is taxed at 50%, with the after-tax proceeds being reinvested at 2.15%.
By the end of the 10-year holding period, the GIC is worth $111,285 after-tax – which is $264 more than in the first scenario ($111,285 – $111,021).
After-Tax Expected Return of a GIC
| Year | Market Value Beginning | Market Value Ending | Market Value After-Tax |
| 1 | $100,000 | $102,150 | $101,075 |
| 2 | $101,075 | $103,248 | $102,162 |
| 3 | $102,162 | $104,358 | $103,260 |
| 4 | $103,260 | $105,480 | $104,370 |
| 5 | $104,370 | $106,614 | $105,492 |
| 6 | $105,492 | $107,760 | $106,626 |
| 7 | $106,626 | $108,918 | $107,772 |
| 8 | $107,772 | $110,089 | $108,931 |
| 9 | $108,931 | $111,273 | $110,102 |
| 10 | $110,102 | $112,469 | $111,285 |
Source: Justin Bender
This blog post is not meant to downplay the tax-efficiency of HBB’s structure. HBB would still be expected to have a higher after-tax return than a traditional broad market bond ETF (such as XBB), which is arguably a more fair comparison. However, for a taxable investor who does not require liquidity and prefers to keep things simple while taking less risk, a GIC is also a suitable option—and might even turn out to deliver a better after-tax return.
Since September 2013, Som Seif’s Purpose Investments has created a Total Return Bond ETF (PBD) which uses the mutual fund class structure to turn interest into capital gains and dividends with its monthly distributions. For a non-registered account, how attractive is this today, with comparisons to PH&N’s RBF1340 Total Return D or iShares XBB Universe Bond Index showing much lower values in 1 month to 1 year total returns (all distributions reinvested, including fractional units).
Are these even comparable, and what about current thinking on HBB and ZDB in the 2015 environment.
We cannot easily buy the fixed income from the six-figure GIC that matures on 4/15 inside an RSP account, making the FI subject to the tax whims of a non-registered account.
Advice on likelihood of net tax benefits — do not want to sacrifice up to half the income just to reduce a fraction of it going to the CRA, if the past trends favour the first-mentioned MF and ETF?
@David Hook – I don’t think any short-term after-tax return analysis would provide any useful insight if PBD’s before-tax returns are so much lower than the rest.
In terms of HBB and ZDB versus XBB, I would expect that HBB and ZDB would come out ahead for a taxable investor.
I expect interest rates to rise sometime in the next 5 years. Would not another advantage of HBB be that as interest rates rise the YTM adjusts higher and therefore one would expect total returns to rise, whereas the GIC low rate of 2.15% is locked in for the 5 years.
@KayT – HBB would have more term risk than a 5-year GIC, so this may be expected to be a disadvantage in the short term if you could predict a rate increase.
Could you explain this statement further? I would expect a GIC to pay a liquidity premium over a bond fund, but you seem to be implying that the bond fund should pay a “term risk” premium. Is this linked to the fact that the weighted average maturity of HBB is closer to ten years (vs the five year maturity of the GIC)?
GICs and bond ETFs obviously have different risks, and all the associated risks should pay some premium. For example, there’s arguably a greater default risk embedded in HBB than a GIC as well. Maybe this is a topic that’s best left for another post, but what’s the accepted model for risk premia on GICs and bond ETFs? If both GICs and bonds serve a similar stabilizing purpose in a portfolio, how should one judge whether GICs are cheap relative to bonds given the different risks involved? How do you price in the loss of rebalancing opportunities due to using a non-cashable five-year GIC?
You briefly noted this at the end, but I think it is worth reiterating that a significant advantage to HBB is its liquidity compared to a 5 year GIC.
Justin, I see that the other contender for taxable accounts, ZDB, also has a yield to maturity of 1.7% and an MER of 0.2%. Currently it has a coupon of 2.3%, which of course, is taxable each year. Would this mean that ZDB would likely be even less desirable than HBB, from an after tax point of view, at current interest rates?
@Tristan – depending on the investor’s tax rate, it is very likely that ZDB would be less tax-efficient than HBB in a taxable account (all else equal).