Horizon Bond Swap-based HBB ETF Is Like “The Little Blue Pill” For Fixed Income In A Taxable Cash Account

As people get older, there are, uhmmm, things that they sometimes need a little help with…

For example, many shift their asset allocations to have more “fixed income”, like bonds or guaranteed investment certificates (GICs) in their portfolios to provide less volatility and a more reliable income stream. Since interest is taxed unfavourably, preferentially holding interest producing fixed income products in tax sheltered accounts (RRSP & possibly a TFSA) can make sense.

However, as the frisky 1%ers that frequent this blog approach retirement, the increased fixed income holdings in their well endowed portfolios could easily overwhelm the tax sheltered space in their registered accounts.

Those with this first world problem would need to also have some fixed income in a tax exposed account. That could be a personal taxable “cash” account for those who are not incorporated, or who are investing using a taxable account attributed to a low income spouse to income split. It could be a corporate account for others.

Could the swap-based Horizon Total Return Index (TRI) ETF that tracks the Canadian Bond Universe tracking ETF (ticker HBB) be just what the doctor ordered?

The magic of swap-based or TRI ETFs is to turn income into unrealized capital gains. Interest income, like from bonds or GICs, is taxed both immediately and unfavourably at your full marginal tax rate. So, this unique fund structure would seem a powerful tax savings tool.

The introduction of sildenafil (Viagra) had the much anticipated response in the price of drugs. Let’s check out Horizon’s Canadian bond (HBB) swap-based ETF in more detail to see if it has a similarly elevating effect on fixed income held in a personal taxable account. Try not to stare. You’re older now. It’s creepy.

What would be the potential benefit for holding the HBB swap-based bond ETF in a taxable account compared to a conventional bond ETF or a GIC?

Let’s look at the risk premium that I described in my last post to quantify how much more return you may get after fees and taxes to compensate you for the increased risks of using the swap structure. For comparison, I have chosen Vanguard’s VAB conventional bond ETF which pays 2.81% interest (2.94% minus its 0.13% management expense ratio). Like other bond funds, the capital value fluctuates inversely to interest rate changes. I have also chosen a 5 year GIC paying 3.2% annual interest – it doesn’t fluctuate in capital value, but your money is locked in. I also added in a US treasury ETF to compare to the Horizon HTB swap ETF that tracks the 7-10yr US treasuries for information, but won’t dwell on them.

Can HBB spice up a lower income spouse’s taxable account?

Well, there is nothing sexy about fixed income, but let’s try. Let’s take a married physician who took the advice of sleeping with their billing agent to income split and pays them $20K/yr for their services… It is their spouse, and I am talking about the billing services!!!

They invest that money, and for their portfolio mix, there will be $100K allocated to fixed income.  The net income after fees and taxes with HBB or a GIC would be similar (2.6-2.7%) compared to 2.25% with a conventional bond fund. Compared to the conventional VAB fund, the risk premium that they would receive for risking the HBB swap-based ETF is 0.44%, or 0.32% for tying your money up in a GIC. Over a 25 year period, that premium would compound and result in a 12% larger account size using the swap-based ETF.

HBB versus conventional ETF

What if they are close to retirement and have built a huge taxable account with $1M now invested in fixed income?

They would be in a higher tax bracket due to their investment income. So, the tax savings are slightly more with HBB, but they are still marginal given that the returns from the fixed income are so low. The increased taxes decrease the conventional bond ETF return to 1.93% – gee… sounds pretty close to the rate of inflation.

swap-based ETF returns

The tax efficiency improves the risk premium to 0.76% for HBB compared to VAB in this higher tax situation. Over a 25 year period, that premium would compound and result in a ~15% larger account value. The GIC is also taxed heavily at this income level, and HBB has a risk premium of 0.48% compared to it.

How about a high income salaried employee who needs to hold some fixed income in their taxable account?

Let’s take a higher income salaried employee who makes ~$250K/yr. They put $26K into their RRSP and $5500 into their TFSA each year.  They have a taxable account on top of that, and want to invest $100K from that as fixed income.

The risk premium for using the swap ETF would be 1.38% compared to the conventional VAB. That seems like a pretty good risk premium and would result in a 40% larger value after 25 years of compounding. However, that is being driven by the fact that the tax on interest income in this setting is super-bad, rather than the swap ETF being super-awesome. The GIC has a small advantage over VAB, but since taxes are the dominant factor at this income level, it still pays much less compared to HBB.

 

swap-based bond ETF

If a high income earner wanted to have fixed income in a taxable account, the swap ETF would seem a viable option. It could help ameliorate the punitive tax treatment.

Overall, using HBB rather than a conventional bond ETF or GIC could result in a 12-40% larger taxable account value over a long period depending on personal income levels. That is the reward for taking the added risk of the swap structure.

However, in addition to the risk of the swap structure, there is also a risk in being “too risk adverse” and using too much fixed income. That is the risk of making returns that are less than inflation, thereby eroding your buying power. These calculations so far have been in “nominal dollars”. When we look further at the risk side of the equation below, we will also adjust for inflation to give “current dollars” that reflect buying power.

The risk premium that HBB commands can result in a larger portfolio value, but the reason for that potential reward is that there are risks to using swap-based ETFs.

The biggest risk is that the government will change the rules and make swap-ETFs illegal. That would cause them to shut down and you could be forced to realize all of the accrued capital gains in one tax year.

That tax event could cause you to pay a higher marginal tax rate than usual – with an effect on your assets similar to the effect some politicians have on libido. It depends on your preferences, I guess, but no photo shopping was needed to convey that point with this picture.

Can the swelling value of a taxable account with the HBB bond swap-ETF withstand an encounter with the politicians?

Let’s model some scenarios that will produce charts reminiscent of a Viagra advertisement.

We’ll start with our 20K/yr in a low income spouse’s taxable account with $100K invested in either HBB (swap) or VAB (conventional) ETFs.

Modelling assumptions:

  • Adjust for 2% annual inflation – this would give us values in “current dollar” buying power.
  • Taxes on investment income calculated annually and subtracted from the portfolio value.
  • If there is a legislative assault on swap ETFs, resulting in a capital gains tax event, then the extra capital gains taxes are calculated for that year and subtracted from the portfolio value.
  • The money left after the frisking will be re-invested as a conventional bond ETF for the remainder of the 25 year period studied.

So, in the low income spouse’s hands, HBB, does seem to have an advantage compared to VAB. Even if they have an unwanted brush with legislation.

However, what would this look like for the highly taxed $250K/yr employee?

For a high income employee, HBB does seem to make the difference between growth and shrinkage of buying power. The longer that they can go before getting hosed by a political cold shower, the better.

You may have noticed that the traditional bond ETF line in the above charts is rather flaccid looking whilst the swap-ETF line is standing to attention – until the politicians come onto the scene. Well, it appears that the swap ETF is like Viagara for fixed income in a personal taxable account. However, even Viagra is no match for the effects of a politician crashing the party.

Joking aside, there is an important message in the above two chart series. With fixed income returning ~3% and inflation at 2%, fixed income largely just preserves wealth in the hands of a low taxed person. In the account of a higher taxed person, the tax drag of ~1.7% plus the 2% loss to inflation means that you would actually be losing buying power by ~0.7% each year. The main purpose of holding bonds in a portfolio is not for returns, but to help dampen volatility and better manage our behaviour. However, if you can have both behavioural ballast and some slow growth, then that would seem preferable.

There would have to be a very compelling reason for using VAB outside of a tax sheltered account to make it worth it. This bond fund may project an illusion of safety in that setting. One of the issues, detailed in the comments section below, is that VAB holds many “premium bonds”. I mentioned, in passing, that the capital value of bonds moves inversely with interest rates.  In the case of VAB currently, this makes much of the return due to interest and then capital loss – very tax inefficient. I used VAB in this simulation because many people are drawn to the higher interest yield on its face, it helped make the point about tax efficiency, and made for some really flaccid growth/shrinkage curves which suited the theme. There are more tax efficient ways to hold fixed income, and we will move on to a “discount bond” fund for our next comparator to HBB in a corporate account.

Post-Simulation Debrief:

  • HBB has a risk premium of about 0.4-1.4% in a taxable cash account compared to a conventional bond fund.
  • The higher the account owner’s income, the bigger the relative benefit.
  • The swap-based ETF should outperform the traditional ETF in after-tax income/growth. It would also have a better risk premium than a GIC at higher income levels.
  • That advantage is lost going forward after a legislative assault, but could be significant if that never happens or does not happen for many years. The more time that elapses before a legislative tax event, the better.
  • When you add inflation eating away at your buying power by 2%/yr and the tax drag on fixed income in a personal taxable account, VAB may be a losing proposition from a returns standpoint. Returns aren’t the main purpose of fixed income in a portfolio, but HBB can overcome that flaccidity problem as long as no politicians show up to ruin the mood.

I started with these personal taxable account cases as foreplay to using HBB in a corporate account. Tax drag in corporate accounts is a little more complicated, but we will have a look at that next.

Next stop in the Sim Lab… HBB in a corporate account.

 

12 comments

  1. I agree that HBB is a good option, but one important point about holding bond funds in taxable accounts – you shouldn’t hold regular bond funds like VAB in taxable accounts as they are very tax inefficient due to the fact that currently they are full of premium bonds due to the long period of falling interest rates. You are taxed on the higher coupon (which is higher than the yield to maturity due to the premium bonds) then suffer a capital loss when the bonds mature, making these funds tax inefficient. You ought to hold discount bond funds like ZDB or strip bond funds like BXF (or HBB) or GICs when you need to hold fixed income taxable accounts as they are much more tax efficient.

    Wrt to the loss of purchasing power of bonds with today’s yields and inflation, – although undesirable, it’s important to remember the role bonds play in the context of the portfolio. We don’t own bonds for inflation protection, we own equities for that. We own bonds to smooth the ride to help us stay invested in a crash and don’t panic sell equities – the big mistake. So if you don’t have enough room for fixed income in your RRSP, just because bonds currently have a negative real return in a taxable account, is not a reason to not hold them in those accounts, as doing so will lower your allocation to bonds, perhaps going above your risk tolerance.

    1. Thanks for the great comments, Grant! VAB is currently a tax inefficient bond fund as you rightly point out, but it does help illustrate the point about tax efficiency making a big difference in this setting. I have had a number of people talk about using VAB in their tax exposed accounts, so I figured this comparison may be helpful. People are drawn to the yield I think. I didn’t want to get into the extra layer of complexity around changes in capital value of the bonds in detail, but I would see the discount bond fund (ZDB) coming in somewhere between VAB and HBB in efficiency. Same with strip bonds or GIC approaches. Would that be your take? I am trying to strike a balance between illustrating a concept without scaring people away with too much complexity vs completeness.

      I agree that the primary role of bonds is to improve returns by stopping us from making human behavioural errors. I actually pontificate a bit on that point in the upcoming corp account analysis of HBB because it fit my Terminator/robot theme for the post. If there are options for bonds to at least preserve wealth (like HBB or to a lesser extent VDB) rather than erode my buying power, then I’d be interested in that. As always, optimization of investments/asset allocation to get the best balance of risk/return should be the primary driver with optimization of taxes in executing that following.

      Thanks again for raising such great issues!
      -LD

      1. Good point about keeping things uncomplicated, which is very immportant, but I wonder if in this case it comes across as being OK to hold VAB in taxable accounts when then are much better options. I think people are drawn to the coupon of VAB, 3.2%, not understanding that the YTM is 2.63% less the MER of 0.13%. As tax must be paid on the coupon and with the capital loss the after tax return is just under 1%. Some if these premium bond funds even have a negative after tax nominal return.

        I agree that HBB makes the most sense from a tax efficiency point of view, notwithstanding the risks, followed by ZDB and GICs which are similar, then the worst being VAB. And even if there is forced cap gains realization at some point, most of that will likely be the recharacterized interest income so still a lower tax hit than would have been if received as interest incomes.

        I use BXF and GICs in corp and taxable accounts and VSC and ZDB in my RRSP as I like to separate term and credit risk, but that’s another topic altogether.

        1. Thanks Grant. I hope that I didn’t give the impression that VAB was ok. It is a loser in taxable account with a flaccid growth line due to the tax issues. I will have to re-look at the article and see if I can make it more clear. That is good feedback. I am going to provide some basic commentary about yield to maturity and premium vs discount bonds in my next simulation type post.

          It is clear to me that you are a much more matured and sophisticated fixed income investor than me. So, I appreciate you giving these perspectives and insights. I am just starting to transition from 15 years of an all equities approach as I start to see the finish line and my risk tolerance is changing. I am working through the details of how to do this for my own benefit as much as anything and these exchanges are very helpful!
          -LD

  2. always enjoy your posts with knowledge and humour!

    I was thinking of using HBB for my corporate account and lower my passive income, but maybe there is a better way. I get an HELOC at prime which I pretend is my bond fund. If the market does crash, then I can use that to invest. I think a higher allocation to equity would work for those in mid career, with stable income and understand the risks.

    1. Hey BC Doc! Great point about the LOC. We have a corp LOC that I keep on standby with the same idea. I am mid-career and have been heavy on equities because of my earning power and time horizon, but am starting to look how I stabilize things as I age and especially as my thoughts on working less increase with each government budget. It’s funny, when I was younger I felt financially invincible and as I age I realize all of the adults who went before me did know something. Reminds me of being a teenager. The more I look at it, the more wrinkles come out. Guess that’s aging too 🙂 It has been a steep learning curve so far for me and I get humbled by some tidbit that I had no idea about on at least a weekly basis either from researching or more commonly another finance buff. Thanks for adding to the conversation.
      -LD

  3. Oh,.. so nicely done. Quirky to talk about FI and (risk)…. discount bonds would have a lower yield but that’s not the point. When stocks slide I want to be able to grab some cash to buy (liquidity), and if they tank, a flotation device (safety). As I have been deliberating over asset allocation % Fi/equity it seems I prefer accept risk for enhanced equity returns and for fixed income a sleepy steady she goes. The charts are great and show the hbb delivers on all occasions and can be quickly accessed.

    Until, dun dun dun, rates rise! Then maybe gics cover the gap.

    1. Hey Phil!

      I actually made the fixed income and risk comments to be a little provocative. It may seem weird to most who read finance blogs and think of fixed income as emotional ballast, but there are many people out there whose basic thought process is “stocks scary – fixed income safe and housing safe”. Even amongst otherwise sophisticated professionals. There are actually some people with portfolios of mostly fixed income because they want to be “safe”. I’ve had real life arguments with them. That approach may work if they have a portfolio way bigger than their spending needs or projected lifespan, but otherwise they are at risk of lifestyle erosion if they don’t pay at least some attention to returns and tax efficiency. It may seem weird to us to think that way, but there are many who do. Sildenafil recently went generic and dropped in price – so maybe I am wrong and lifestyle will be maintained 😉

      I think the discount bond ETF is interesting. Essentially a lower yield, but more capital preservation instead. Almost like a partial swap-ETF in effect, but not legislatively vulnerable. I am using ZDB as my comparator in the corp account simulation where corporate accounts suffer attacks by the T2 Legislator [you pronounce that in an Arnold Schwartzenegger voice]. “I’ll be back…”
      -LD

  4. Hello LD,

    If I was to buy a bond in my Corp account. It would be ZDB.

    Aside from my kids’ university costs, I haven’t seen too much inflation. Gas is more expensive but I don’t drive all that much. Houses got more expensive but I bought mine already. My latest 2016 Subaru was EXACTLY the same price as my 1999 Honda Odyssey. Electronics are waaay cheaper and so are most forms of entertainment.

    Now I am not saying there is no inflation. Just that I haven’t experienced it prohitively. I am buying equities because it is the simplest way to invest. Just don’t stick so much in that you can’t handle the draw downs.

    Odd rant I know but I’m waiting for my laundry to finish so I can hang it outside. Dang it. Another free thing- sunshine.

    1. Hey Dr. MB,
      It is interesting. Reported inflation is a standard basket of things, but really as an individual, inflation differs greatly depending on what you spend your money on. It is also interesting that for many people, their wages haven’t kept pace with inflation. However, those same people have giant TVs, cell phones, computers, vacations, and other luxuries that previous generations with “higher wages” would only dream of. I have a little Subaru also, although I have been biking more than driving lately with the return of nice weather. Enjoy the sunshine!
      -LD

  5. Hi LD:

    I have been thinking about bonds more. I am going to hold it in my corp but don’t want it to generate too much passive income. Do you think a combination of ZDB/HBB would work?

    1. Hey BC doc. Actually my next comparison is ZDB vs HBB in a corporate account. Part 1 comes out on Friday. Both work. How much better HBB works in the short-term depends on a few factors and needs to be weighed against the other risks longer-term.

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