On June 11, 2013, First Asset released a new short-term bond ETF comprised entirely of strip bonds. It seemed like an odd choice at the time, seeing as there were already many short-term bond ETFs available to Canadian investors. Relative to the existing products, the First Asset 1-5 Year Laddered Strip Bond Index ETF (BXF) was expected to give investors a leg up when they held the ETF in their taxable accounts (Dan Bortolotti discusses the reasons for this in his blog post Why Use a Strip Bond ETF?) .
Has this been the case in practice? Although it is too early to compare the after-tax returns for the 2014 tax year, we do have access to six months of data from July 2013 to December 2013. While I admit this is an extremely short time frame, it should give us some insight into whether the strip bond ETF has been more tax-efficient than other plain-vanilla bond ETFs.
Using the same methodology found in our white paper, I’ve calculated the after-tax returns and the tax cost ratio of various short-term bond ETFs. The results were not surprising; the strip bond ETF had a higher after-tax return and a lower tax cost ratio (which is a good thing) relative to the other ETFs. It also had a higher before-tax return, but this may be the result of its higher duration and First Asset’s no management fee promotion over the period.
6-Month Before vs. After-Tax Return Comparison: July 2013 – December 2013
Tax Cost Ratio
|First Asset 1-5 Year Laddered Government Strip Bond Index ETF (BXF)||
|iShares Canadian Short Term Bond Index ETF (XSB)||
|BMO Short Provincial Bond Index ETF (ZPS)||
|Vanguard Canadian Short-Term Bond Index ETF (VSB)||
iShares 1-5 Year Laddered Government Bond Index ETF (CLF)
Sources: CDS Innovations Inc., First Asset, BMO ETFs, BlackRock Canada, Vanguard Canada, Justin Bender, CFA, CFP
Before deciding on which bond ETF to purchase, it is important for taxable investors to understand the impact that improper product location can have on their after-tax returns. Bond ETFs that trade at a premium to their par value (such as XSB, ZPS, VSB and CLF) should be restricted to tax-deferred and tax-free accounts. Strip bond ETFs (such as BXF) may be a more tax-efficient solution for investors who hold bond ETFs in their taxable accounts.
Hi Justin, Thank you for all the informative articles. I have a question about BXF, since the strip bonds themselves pays no interest and the fund is paying distributions based on a cash reserve, does that mean the distributions will be counted as Return of Capital and maybe some capital gains (from selling the bonds each year)?
@Andrew – it’s likely that BXF will have a portion considered return of capital (usually to smooth distributions), but First Asset will still have to allocate the accrued interest of the bonds to the unitholders. Any capital gains realized on the sale of a bond will also have to be allocated to the unitholders.
Just wondering about the CRA reporting requirements for the stripped bond ETF.
If held in your regular account, do you need to report the implied interest income of the bonds in the ETF on your tax return every year even if you don’t sell the ETF? Will the ETF supplier provide the necessary data, or is this a calculation that holders will have to do? If so, any handy calculators you can recommend?
@Gail Bebee – from what I understand, First Asset holds a small cash allocation within the ETF, which they use to distribute the annual taxable accrued interest to unitholders (via a T3 slip). So the record-keeping would appear to be much more straight-forward than if the investor held individual strip bonds in their taxable accounts.
Why no love for the almighty Horizon HBB ?
@Laweencew – the post was meant to be a comparison of the after-tax returns of short term bond ETFs – HBB should be compared to a broad-market bond ETF.
Justin, This seems like a very interesting ETF to consider holding in my taxable account, but despite being on the market for 6 months and a no fee promotion it remains very thinly traded. I think today there were no trades if my financial data feed is correct. Should this not be a warning sign that there is something wrong with the strategy or the operations of this ETF?
@KayT – this lack of interest is most likely a case of investor/advisor inertia. The BMO Discount Bond Index ETF (ZDB) appears to be suffering from the same problem (with only about $20 million in AUM). I am hopeful that ongoing after-tax return comparisons will help these products gain more acceptance with investors and advisors.