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When should I use the BMO Discount Bond Index ETF (ZDB)?

October 28, 2014 - 6 comments

The BMO Discount Bond Index ETF (ZDB) has been slow to gather assets since its launch in early 2014. This may be due to investor inertia or confusion over the reasoning behind holding discount bonds. There are generally two situations in which an investor may want to consider investing in ZDB rather than the more popular BMO Aggregate Bond Index ETF (ZAG):

1. They hold all of their bonds in a taxable account

With bond yields hovering near record lows, some investors have opted to hold bonds in their taxable accounts and stocks in their RRSP accounts. The issue with this strategy is that lower bond yields do not necessarily mean lower bond coupons. ZAG and ZDB both have a yield-to-maturity of 2.3% (which is the best estimate we have of their future before tax returns). But ZAG has an average taxable coupon of 3.9%, while ZDB has an average taxable coupon of 2.3%. All else equal, an investor would be expected to pay less tax and have higher after-tax returns if they held ZDB rather than ZAG in their taxable accounts.

2. They hold some of their bonds in a taxable account

For investors that hold the same mix of bonds and stocks in their RRSP and taxable accounts, using ZAG in the RRSP and ZDB in the taxable account will also likely result in higher after-tax returns (all else equal).

As most investors know, “all else” is not always equal. The selection of discount bonds in the Canadian marketplace is slim pickings, making a discount bond ETF like ZDB more exposed to corporate issuer risk than a broad market bond ETF like ZAG. For instance, ZDB holds over 3% in Telus corporate bonds, whereas a typical bond ETF would have less than a 1% allocation to the same issuer.

When does it not make sense to use ZDB?

If you hold all of your bonds in an RRSP account, it makes little sense to invest in ZDB. A plain-vanilla bond ETF like ZAG would be the preferred choice, due to its increased diversification.

By: Justin Bender with 6 comments.
  10/02/2017 10:33:45 AM
Justin Bender
@carl: ZDB and BXF will be more tax-efficient than plain-vanilla bond ETFs when the weighted average bond coupon of the underlying holdings is higher than the weighted-average bond yield.

Even as the shorter-term bonds mature, the ETF may be buying bonds with a shorter maturity that were issued many years ago (as a long term bond with a relatively high coupon), so it will likely take some time before this premium bond issue is resolved.
  09/02/2017 12:47:08 AM
Thanks for the information. .quick question...are zdb and bxf etfs only tax efficient compared to regular core bonds etfs when the interest rates go down?...after the premium bonds mature I assume the core bond etfs will buy bonds where the difference between coupons and yield is much less making this more tax efficient making it comparable to bxf or this reasoning correct? Thanks
  31/10/2014 9:22:15 AM
Justin Bender
@Anne - HBB would be expected to be more tax-efficient in a taxable account than ZDB (as long as you are comfortable with the swap structure)
  31/10/2014 2:09:14 AM
Would HBB be more tax efficient than ZDB in a taxable acct. i'm contemplating moving from XBB in RRSP to HBB in taxable acct., then using freed up RRSP room for VTI and VXUS
  29/10/2014 2:52:34 PM
Justin Bender
@Scott S - it's difficult to say whether ZDB will become more tax efficient (this will depend on the extent of the yield increase as well as the availability of Canadian deep discount bonds).

As long as you stay away from any bond ETFs where the coupon is higher than the yield-to-maturity, you should be on the right track (high interest savings accounts, GIC ladders, strip bonds or discount bonds would all be options to consider)
  28/10/2014 7:15:14 PM
Scott S
Thanks for the post.

So does it make sense that as bond yields rise ZDB will become increasingly tax efficient? I guess a larger component of the return is shifted to the cap gain when the discount bond reaches maturity, therefore helping tax efficiency.

I just want to make sure I'm understanding the concept correctly.

I'm constantly trying to figure out the most tax efficient way to hold bonds in a non-registered account. As far as I can tell it is either discount bonds, a product like HBB (a little sketchy + that extra swap fee), or a GIC ladder (liquidity issues).

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