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.
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).
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).
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.