This question was directed to me by an investor a few days ago – they had read a posting on PrefBlog.com 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.