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):
- 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 |
$50,000 |
Sources: BMO Asset Management, PWL Capital
- They hold some of their bonds in a taxable account
For investors that hold the same mix of bonds and stocks in their RRSP and taxable accounts, using ZAG in the RRSP and ZDB in the taxable account will also likely result in higher after-tax returns (all else equal).
Example: Balanced portfolio using ZDB in a taxable account and ZAG in an RRSP account
Exchange-Traded Fund (ETF) |
Allocation (%) |
Taxable Account ($) |
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
Wow, $0.63 per unit phantom capital gain in 2020. That’s really disappointing.
@Bjorn: It’s an expected outcome for ZDB whenever bond yields decrease (like they did in 2020). When this occurs, the bond prices will increase (making them trade at an even higher premium to their par value). ZDB will then need to sell these bonds and repurchase bonds with lower coupons (realizing capital gains in the process).
BMO was doing exactly what they should be doing with the tax management of ZDB.
does it still make sense to buy ZDB in a non registered account giving the low yields these days?
I’m wanting to re-balance my 60/40 portfolio and it requires a large purchase of ZDB to meet my target.
I’m just not sure with the current low yields, or should i wait on the fence a bit.
Thx
@Victor Sanchez: With my clients, I generally still use a mix of 1-5 year GICs and ZDB in taxable accounts. Trying to time interest rate movements is likely to be a futile exercise.
Hi Justin, been following the XAW, ZAG, ZAG model since 2018. My ZAG now entirely sits in my margin account, would it be worthwhile to sell the ZAG and buy back into ZDB?
@Stephen – it would depend on your overall tax situation. In episode #5 of the CPM podcast, I compared the after-tax returns for ZDB vs. ZAG, VAB and XBB for a top rate Ontario taxpayer, and found that an investor holding ZDB would have earned higher after-tax returns than the other comparable bond ETFs:
https://canadianportfoliomanagerblog.com/podcast-5-wrapping-your-head-around-the-ridiculous-model-etf-portfolios/
Forgive me, but what does the last C in CCPC mean? Its driving me crazy. I assume the CCP, Canadian Couch Potato, but the last C is?
@moneyhelp: CCPC stands for “Canadian-controlled private corporation” – it has nothing to do with CCP/Canadian Couch Potato.
Oh wow, I was way off, but thank you for clarifying.
On another note, would love to see any future YouTube videos as I love those, because they are very helpful, specifically those with Questrade, as you may remember, that is my brokerage and I believe yours as well.
Thanks!
@moneyhelp: Shannon and I will be releasing more YouTube videos in the fall, so stay-tuned!
HI Justin,
I need to put a large amount into fixed income. Currently I am using GICs but they are getting too numerous to stay within the CDIC limits.
I was thinking of using ZDB for my CCPC. But I realize that it will breech 7 figures.
Do you think that it is safe to use ZDB for such a large amount? Or would you recommend using combos of ZDB and ZAG or VAB in my CCPC? Even though it is less tax efficient but ZAG and VAB seem to hold more bonds diversification as you state in your writeup.
@Emily: I invest large 6-7 figure amounts of ZDB in taxable client accounts and am comfortable with the credit risk (it should be minimal with mostly government bonds and investment grade issuers).
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
Hi Justin, with really low interest rates in savings accounts these days (around 0.1% at tangerine, and 1.25% at EQ), I think I’d be better off putting my savings/emergency fund in ZDB since the yield is about 2%. Anything wrong with my thinking here?
@Noob – Savings accounts don’t fluctuate in value, whereas bond ETFs like ZDB will. ZDB has lost between 4-5% of its value YTD. And during the pandemic, ZDB experienced a loss of nearly 13% over just 5 trading days (this was a time when many Canadians were out of work and may have needed to tap their emergency fund). So ZDB (or any bond ETF) is not a replacement for a savings account.
So then is there a point of using bonds, as opposed to keeping it in a savings account? It seems like the point of a bond ETF is so that in a downturn, you hope that your bonds go up to soften the blow and then you can sell it to buy more stocks (except like you mentioned, bonds alsowent down during the pandemic in March 2020)
@Noob – Bonds still serve a useful role in a diversified portfolio. In periods of falling interest rates, they can increase in value (the opposite can be said about your cash holdings). They can also potentially lower the volatility of a portfolio (even more so than cash). However, it could also make sense to keep a portion of your portfolio in cash (for liquidity reasons, or to protect against rising interest rates).
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?
@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.
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?
@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.
Okay, thanks for your thoughts!
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.)
@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.
How do you feel about using HBB instead of ZDB?
@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.