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Can You Earn a Negative After-Tax Return on a Bond ETF?

February 17, 2012 - 4 comments

This question was directed to me by an investor a few days ago – they had read a posting on that claimed investors should avoid holding bond ETFs and bond mutual funds in their non-registered accounts when the weighted average price of the underlying bonds are trading at a premium.

The disappointing answer is…yes, you can technically have a negative after-tax return on a bond ETF or bond mutual fund when holding either security in a non-registered account. I’ll illustrate this phenomenon using the iShares DEX Short Term Bond Index Fund (XSB) as an example (but it could just as easily be a bond ETF or bond mutual fund from another provider).

As of January 31, 2012, XSB had the following information available on their website:

Since the average coupon of the bond portfolio is higher than the yield to maturity (3.40% versus 1.49%), this would indicate that the weighted average price of the underlying bonds is above $100 or par (i.e. the underlying bond portfolio is trading at a premium). In this example, the approximate weighted average price of the underlying bond portfolio is $105.292*.

Let’s assume that we purchase $105,292 of XSB and that it matures in 2.84 years at $100,000 (this is completely theoretical, as bond ETFs never mature). This would result in a capital loss of $5,292 ($100,000 - $105,292) and total coupon interest received of $9,656 ($100,000 x 3.40% x 2.84).

The investor would also pay the fund an approximate MER of $787.09**, which would be deducted from the coupon interest before distributing it to the client, resulting in taxable coupon interest of $8,868.91 ($9,656 - $787.09).

If the investor is in the highest marginal tax bracket, they will pay approximately 46% of the interest to the taxman, or $4,079.70 in taxes ($8,868.91 x 46%).

So to sum up, here are the results (assuming the fund does not have any capital gains to offset the capital losses):

This would imply an annualized after-tax return of approximately -0.17%!

If the fund was able to offset the $5,292 capital losses against capital gains triggered by the fund, the investor would be able to save $1,217.16 in taxes ($5,292 x 50% x 46%), resulting in a total net dollar return of $714.37 (-$502.79 + $1,217.16), or an annualized after-tax return of 0.24%.

The main take-away from this analysis is to consider holding bond ETFs and bond mutual funds in registered accounts when the average underlying bonds are trading at a premium to par (as most bonds are today). If you must hold fixed income in your non-registered accounts, consider holding GICs (if you do not require the liquidity) or high-interest savings accounts if liquidity is a concern.


The helpful comments of Raymond Kerzerho are gratefully acknowledged. 



By: Justin Bender with 4 comments.
Filed under: Performance
  07/07/2017 4:51:32 PM
Justin Bender
@David Cox: You may find the following blogs more useful (I’ve already calculated the after-tax returns of various bond ETFs):

You are correct in your assumption that the tax-inefficiency is caused by underlying bonds in the ETFs that are trading at a premium to their par values. The BMO Discount Bond Index ETF (ZDB) and the First Asset 1-5 Year Laddered Strip Bond Index ETF (BXF) are structured to mitigate this tax-inefficiency.
  05/07/2017 6:25:58 PM
David Cox
Justin, I found this article through one of Don's CouchPotato articles. I was unable to replicate the PV solution using either my well-conditioned 1980's HP12C ($104.143) or using Excel's PRICE function ($105.502). Yours assumed a semi-annual Payment - is that what XSB did in 2012 as currently it is monthly which would change the end result some. I don't think the DAY/COUNT basis (I used 30/360) would change the result materially. Anyway, XSBs current Wtd Avg Coupon is 2.51%, YTM is 1.69% and no material change in Maturity nor MER - the capital loss is 45% of your example and results in a positive implied annualized return before and after capital loss offset. Notwithstanding the bond fund is trading at a Premium, would it be a safer bet to conclude that when that premium is closer to Par ($102.53 with current variables), one would not earn a negative after-tax return on a Bond ETF and this would make it acceptable to include in a non-registered account? Thank you
  27/02/2014 9:45:48 AM
Justin Bender
@Christian - the inputs were based off of a semi-annual pay bond - for example:

N = 5.68 (which is 2.84 years x 2)
I/Y = 0.745 (which is the 1.49% YTM / 2)
PMT = 1.70 (which is the 3.40% coupon / 2)
FV = 100 (which is the maturity or par value of the bond)
  23/02/2014 6:50:26 PM
Very informative post.
How are the inputs for the financial calculator obtained?

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