• Investment Taxation

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

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.

Example:  Balanced portfolio using ZDB in a taxable account

Exchange-Traded Fund (ETF)

Allocation (%)

Taxable Account ($) RRSP Account ($)
BMO Aggregate Bond Index ETF (ZAG)

0%

$0

BMO Discount Bond Index ETF (ZDB)

40%

$40,000

BMO S&P/TSX Capped Composite Index ETF (ZCN)

20%

$10,000

$10,000

BMO S&P 500 Index ETF (ZSP)

20%

$20,000

BMO MSCI EAFE Index ETF (ZEA)

20%

$20,000

Total

100%

$50,000

$50,000

Sources:  BMO Asset Management, PWL Capital

 

  1. 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).

Example:  Balanced portfolio using ZDB in a taxable account and ZAG in an RRSP account

Exchange-Traded Fund (ETF)

Allocation (%)

Taxable Account ($)

RRSP Account ($)

BMO Aggregate Bond Index ETF (ZAG)

20%

$20,000

BMO Discount Bond Index ETF (ZDB)

20%

$20,000
BMO S&P/TSX Capped Composite Index ETF (ZCN)

20%

$10,000

$10,000

BMO S&P 500 Index ETF (ZSP)

20%

$10,000

$10,000

BMO MSCI EAFE Index ETF (ZEA)

20%

$10,000

$10,000

Total

100%

$50,000

$50,000

Sources:  BMO Asset Management, PWL Capital

 

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.

Exchange-Traded Fund (ETF)

Allocation (%)

Taxable Account ($)

RRSP Account ($)

BMO Aggregate Bond Index ETF (ZAG)

40%

$40,000

BMO Discount Bond Index ETF (ZDB)

0%

$0
BMO S&P/TSX Capped Composite Index ETF (ZCN)

20%

$20,000
BMO S&P 500 Index ETF (ZSP)

20%

$20,000
BMO MSCI EAFE Index ETF (ZEA)

20%

$10,000

$10,000

Total

100%

$50,000

$50,000

Sources:  BMO Asset Management, PWL Capital

By | 2017-01-17T15:03:20+00:00 October 28th, 2014|Categories: Investment Taxation|Tags: |10 Comments

10 Comments

  1. Adam November 5, 2014 at 10:47 am - Reply

    I understand the concern regarding HBB but imho by not using it, the indivudal investor prohibit himself from using the most efficient bonf ETF.

    Yes, HBB is at risk of the CRA wrath but suppose the CRA crackdown on swap based product this would only mean triggering early capital gains for investors. This remote but real possibility is still better than paying tax on years and years of unwanted distributions… Do the math for 2,5,10y at 2.5% distribution per year 🙂

    We also need to consider that there already billions and billions of total swap arrangement in the market

  2. Andre November 4, 2014 at 6:56 am - Reply

    Do you see a considerable advantage at this time for using this etf instead of going to a GIC when the only room you have is in an unsheltered account?

    • Justin November 4, 2014 at 8:07 am - Reply

      @Andre – I tend to favour GICs in a taxable account when working with clients (after we rebate the GIC commissions, the expected return is similar to the yield to maturity after fees on a broad-market bond fund, but with less term risk). We do use the DFA Five-Year Global Fixed Income Fund Class F (DFA231) in taxable accounts as well in order to have some liquidity for rebalancing and surprise calls from clients for capital.

  3. Scott S November 4, 2014 at 12:13 am - Reply

    Hey Justin I was posting on your PWL Capital blog before, but I was wondering what your feelings on ZDB are. With a market cap of $20M, do you think it is still too small to be used as a primary holding?

    • Justin November 4, 2014 at 7:59 am - Reply

      @Scott S – I don’t see any huge issues with investing in ZDB (even though it has assets under management of $20M). The fund may be expected to have a larger than usual tracking error to its index (either positive or negative), but the greater tax-efficiency (relative to ZAG) would be expected to make up for this.

  4. Tyler November 3, 2014 at 5:29 pm - Reply

    Okay, thanks for your thoughts!

  5. Tyler November 3, 2014 at 4:01 pm - Reply

    So when would you feel comfortable assuming that the CRA won’t change its policy towards Horizons’ swap-based ETFs? For example, HXT/HXS have been around, unchallenged by the CRA, for about 4 years now.. are they “safe”? How long would HBB have to be untouched for you, to consider it safe, to use with your clients? Or would you really only use them if the CRA explicitly stated that they’re ok with swap-based products?

    (I realize I’m asking for you to speculate, so I realize you might not have a specific answer.. I’m just curious on what your thoughts are when considering whether a product is appropriate to use.)

    • Justin November 3, 2014 at 5:14 pm - Reply

      @Tyler – if CRA were to give a definitive response that they had no plans to target this type of swap structure, or Horizons could provide a detailed and compelling analysis on why CRA would have no reason to target this type of swap structure, I would be more inclined to consider these types of products for inclusion in client portfolios.

  6. Tyler November 3, 2014 at 3:38 pm - Reply

    How do you feel about using HBB instead of ZDB?

    • Justin November 3, 2014 at 3:45 pm - Reply

      @Tyler – I haven’t started using HBB (or any swap-based ETF) with clients. If CRA leaves the tax treatment of these products alone, they may very well be the most tax-efficient fixed income solution for investors.

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