HBB Swap-ETF or ZDB Discount Bond Fund In a Corporate Account Versus The Legislator

Horizon’s HBB Canadian Bonds Total Return Index (TRI ETF) could play a role in the corporate investment accounts of Canadian high income professionals.

The Model T2 Legislator changes the laws to collect more tax from professionals and businesses.

We are not machines. One of the frailties of being a human investor is that we can easily fall prey to our emotions. Big swings, or volatility, in the value of the holdings in our portfolio play to the powerful base emotions of fear or greed – driving us to buy or sell at the worst possible times.

Successful investors control their behaviour with many strategies, but one is to have fixed income (like bonds) in their portfolio. Fixed income grows more slowly and over time returns less than equities, but it also dampens volatility to sooth our inner beast and prevent even worse returns due to bad investor behaviour.

One of the downsides of fixed income is that it is taxed brutally. So, for those who want fixed income as part of their asset allocation, tax efficiency is important. The simplest way to avoid or defer taxes is to hold fixed income in a tax sheltered account like an RRSP or TFSA.

However, high income professionals may run into problems with that because they save so much that they overwhelm the space in their registered accounts. Further, it may also not always be the best usage of that precious tax sheltered space depending on your overall plan.

Many doctors and other small business owners have gone the route of using a Canadian Controlled Private Corporation (CCPC) as their only investment vehicle, making discussion of registered accounts a moot point  for some (other than that maybe they should be re-considering that approach).

Considering use of the HBB swap-based ETF means considering the potential risks and benefits compared to a more conventional bond fund.

The swap contract structure of HBB can convert interest income into capital gains to reduce taxes. This can revive the limp growth curve of fixed income in a taxable cash account. While more convoluted, a corporate investment account is also exposed to the effects of tax drag, and the swap-based HBB could have similarly arousing prospects within a professional corporation.

All swap-based ETFs come with some general risks, but the most concerning of these is legislative risk. Hence, we will also model the potential damage done to our corporate account if we have another attack by The Legislator.

The risk premium for the HBB bond TRI ETF held in a corporate account is largely impacted by three factors:

  • Whether the passive investment income causes the CCPC to have more active income over the new active-passive income SBD tax threshold, resulting in a bump into the higher general corporate tax rate.
  • The CCPC paying out enough ineligible dividends to trigger release of their refundable dividend tax on hand (RDTOH).
  • If the investment income does bump the CCPC into the general corporate tax rate, whether the corporation pays out enough eligible dividends to empty out the generated GRIP and blunt the tax bite.

We will quantify the potential benefit of swap-based HBB relative to a conventional discount bond ETF (ZDB) by calculating the risk premium under different conditions in a corporate account.

What is the difference between VAB and ZDB?

In my first simulation comparing HBB vs VAB in a taxable account, I only touched lightly on the piece about changes in the capital value of bonds. Bonds are complex in some ways, and I want to build our knowledge base one piece at a time about them. That post made the point about the tax efficiency of HBB vs VAB. However, as rightly pointed out in the comments section, VAB is a rather tax inefficient way to hold bonds in a tax exposed account due to the high concentration of “premium bonds”.

Most people think of the interest on bonds, but bonds also fluctuate in capital value before maturity  inversely to the current interest rates. Bonds that pay an interest rate higher than the current prevailing rate have more capital value when bought and sold on the secondary bond market and are “premium bonds“. Those with a lower interest rate are “discount bonds” and have a lower capital value.

The reason for this is easier to understand if you think about bond sellers competing for your money. If you can go out and buy a new issue $100 bond paying 6% interest and maturing in 5 years, and I am selling a 10 year bond with 5 years left to maturity that pays 3% interest, then you are not going to be willing to pay me $100 for it. If you are, then I have some other great stuff to sell you! You would maybe pay closer to $50 for it to make the yield on your investment comparable. You would be buying it at a discount.

When a bond matures, it triggers a realized capital gain or loss as if sold for the value that it was originally bought for at the time of issue. This is called the par value, and the difference between the price that the bond was purchased at on the secondary market and the par value results in a realized capital gain or loss. Using the above example, in 5 years you would redeem the “discount bond” that you bought from me for the $100  face value and realize a $50 capital gain.

Since capital gains are taxed at half the rate that interest income is taxed at, using discount bonds is a more tax efficient way to hold bonds in a tax exposed account. This conversion of interest income into capital gains with discount bonds is functionally similiar to a partial swap-based TRI bond ETF without the legislative risk from the swap-structure.

To help us get a sense of how much income a bond will generate for us from both the interest paid and the capital gain/loss on a yearly basis if held until maturity, we look at the yield to maturity (YTM). The calculation of YTM is complicated, but we can use this to both decide if a bond meets our return expectation and to get an idea of how much of the total return would come from capital gains versus interest to judge its tax efficiency.

The values are changing frequently, but in the table below, I summarize the most recent information that I could find on some common bond funds to estimate their return after fees and the income type. I will use that information for our scenario below comparing HBB and ZDB.

HBB ZDF VAB XBB

Introducing Dr. Sarah Connors –  a mid-career high income specialist & moderate saver with average risk tolerance

HBB swap-based ETF doctor
Linda Hamilton as Sarah Connors in Terminator 2, Orion Pictures, 1991.

Dr. Connors is a 50 year old cardiologist in Ontario. After years of toil and risking significant capital on medical equipment and infrastructure, she has built a thriving practice that nets $500K/yr of active business income.

It is hard for her to scale back when she has so much money invested into her infrastructure and several employees dependent upon her enterprise. She enjoys being ruler of the cardiac kingdom that she has built. Further, she is also the only cardiologist serving her a large rural area and is not easily replaced.

She has no intentions of retiring or slowing down for at least 15 years for all of the above reasons.

Over her career to date, she has built up a $3M portfolio in her CCPC account. She wants $1M of that to be allocated to bond funds. She lived through the 2008 financial crisis and has seen the effects of stress too many times to want too much volatility in her portfolio – especially as she ages and her coronaries narrow further.

Her $2M in the equity allocation has an eligible dividend yield of 2.5% or $50K/yr. If using the conventional discount bond fund (ZDB), yielding 1.95%/yr from interest income and 0.69%/yr from unrealized capital gains, then she gets another $19500/yr addition interest income. She would pay 50.17% tax on the interest income up front. This results in a 0.76%/yr risk premium favouring HBB.

bond investing professional corporationThe upfront tax paid on passive investment income in a CCPC is high to prevent it from being used as a tax deferral vehicle. However, that sting can be attenuated by Dr. C triggering her refundable dividend tax on hand (RDTOH). That can be released if she pays out some of the profits in her corporation as dividends. This also greatly reduces the risk premium that she would get for braving the swap-ETF structure to only 0.38%.

swap ETF discount bond MPCIf Dr. Connor is already paying herself enough dividends to trigger her RDTOH, then the low risk premium of HBB may not be worth it to her. If she lives off of salary, or so few dividends that she does not trigger all of her RDTOH, then the risk premium for using the TRI bond ETF would be somewhere between 0.38% and 0.76%.

Dr. Connor has no problems paying herself enough dividends as part of covering her living expenses to trigger her RDTOH. With the minimal risk premium for using HBB, she decided not to bother with it. Dr. C’s practice and financial plan was ticking along like a well-oil machine until…

Following a flash of light from either a tear in the space-time continuum or multiple cell phone cameras taking selfies – out of the ether appears…

The Legislator

new passive business income tax
credit: The Terminator, 1984, Orion Pictures.

Sent back in time from a future where people stopped working due to punitive income tax rates and escalating payroll costs – they were replaced by automated check-outs, robotics, and other machines.  The T2 Legislator’s secret time travel mission is to accelerate that process.

Recognizing that a CCPC allowed small business owners to defer some taxes into the future and invest more, T2 passed the 2018 federal budget to force taxation of corporations with >$50K/yr of investment income into the present.

What happens to the risk premium of HBB compared to ZDB when investment income pushes a CCPC above the active/passive income threshold for the small business tax deduction?

swap ETF avoid tax
Even with the lower stress of her rural lifestyle and some fixed income in her portfolio, Dr. C really should quit smoking.

Between her $50K/yr dividends and $19500/yr interest, Dr. Connor is over the newly legislated $50K aggregate investment income threshold. Her small business deduction (SBD) for active business income is reduced by $5 for every dollar of passive income over the limit.

The Legislator attack restricts her favourable SBD tax rate (12.5%) to the first $402500 of active income earned, and the remaining $97500 is now taxed at the general corporate rate of 26.5%. She will now pay $76150/yr in tax on her active business income instead of $62500/yr – an extra $13650!!!

Dr. Connors enjoys her rural lifestyle and career, but does not want to lose more income to taxes than she needs to. She plans to fight back using the swap-based bond ETF instead of a conventional one in her corporate account. 

If Dr. Connors were to use HBB instead of ZDB, then she would not only defer and pay less tax on the investment income, but also less tax on her active business income.

How much could that change her annual returns by?

swap ETF CCPC taxAs shown above, T2 has terminated the income advantage for leaving money invested (down to a 0.30% net return) in a conventional bond ETF in Dr. Connors’ medical professional corporation (MPC). Due to that tax bomb, the risk premium for using HBB is huge because it essentially defuses it. The Legislator does not want money to be sheltered from tax and Dr. Connor can comply by taking money out of her corporation as described in the next section.

Fortunately, the reality for most physicians would not be nearly this stark when we account for triggering refundable tax and releasing our GRIP.

We don’t just leave all of our money in our corporation –  we need money to live on! This reality of the human condition can soften the tax blow and reduces the risk premium of HBB for most of us because we pay enough dividends to trigger release of our RDOTH.

Of the ~50% of tax collected on taxable investment income (other than eligible dividends), 30.67% goes into our nRDTOH and 20% is non-refundable. To release that refundable portion, we need to give an ineligible dividend of $2.61 for each dollar of nRDTOH to be refunded. We pay personal tax on that ineligible dividend and the nRDTOH is refunded to our corporation.

A similar process happens with eligible dividends and eRDTOH, except it is 38.33% collected and refunded. With her corporation collecting $50K/yr eligible dividends from her investments, she generates $50K/yr GRIP from that. She also generates another $35K/yr in GRIP from her active corporate income that was bumped up to the higher corporate tax rate. This GRIP balance means that she can pay herself $85K/yr as more favourably taxed eligible dividends.

In addition to basic human needs, Dr. Connors spends a fair bit on her lifestyle – plus her guns, smokes, and ammo. To pay for her lifestyle and arsenal, she dispenses herself 136K/yr in dividends. This is enough to release both the nRDTOH from the tax on her bond interest and give enough eligible dividends to use up her GRIP balance.

HBB bond swap ETFWhile tax integration is not perfect, it is pretty good and mitigates much of the tax loss. Taking the risks of the swap-based ETF structure for her bond fund pays a risk premium of 1.13%/yr. This is now much more enticing for her to use the TRI bond ETF compared to the risk premium of 0.38% if she were not caught up in the recent attack on CCPC investing by the T2 Legislator.

She could pay herself as little as $136K in dividends to trigger all of her RDTOH and GRIP. If she were to require less income paid out as dividends, then the risk premium for using HBB rises (up to a maximum of 2.12%). That would make HBB progressively more attractive.

The potentially improved after-tax return for swap-based bond ETF vs a conventional discount bond ETF in a corporate account varies by cicumstances…

  • If your active and passive investment income do not bump you over the new SBD threshold putting you on the list for termination by The Legislator, then the risk premium of HBB over ZDB is small (0.38% to 0.76%) depending on whether you give enough dividends in supporting your personal spending to release your RDTOH.
  • If you are targeted for termination, then the risk premium for HBB relative to ZDB grows to 1.13% to 2.12% depending on how many dividends you pay out.
  • An alternative way to dodge the mechanized assassin would be to lower your active business income by paying out salary. Whether or not salary is a superior strategy will depend on how well tax integration works for your situation plus how you view the other pros/cons of using salary. This will be an upcoming series of posts. Your spending requirements will also factor in. Whether your spending justifies dispensing enough dividends to trigger RDTOH and GRIP affects the tax efficiency of your corporate investments, as shown in this post . That is not a problem for my high-cash-burn-rate family, and I will soon start fessing up to those some of those facts in the M & M Rounds section of the blog.

The HBB swap-based ETF successfully defeats the recent attack of the T2 Legislator on small business investment income. However, just like in the movies, I don’t think that we have seen the last of him…

 

 

 

17 comments

  1. Wow, great example and explanation LD. Thanks for all the hard work putting these posts together. It’s hard to find useful quality information like this. Pls keep it up:)

  2. Great post, LD! I think I’m finally beginning to get my head around GRIP and RDTOH, and using the risk premium concept for the funds is a good way of looking at it. I use BXF in my corporate account. Would you consider adding that to your risk premium analysis, wrt to ZDB and HBB? It’s a discount bond fund, all government bonds, with a shorter duration (2.6 years) than a total bond fund. It has a yield to maturity of 2.17% with no coupon, being a discount bond fund, but does pay out a quarterly cash payment giving a taxable distribution yield of 1.21%. I don’t really understand why it does that. Anyway, I use that fund because I like to seperate term and credit risk, when a crash and flight to safety occurs, government bonds rise in price and corporate bonds either stay flat or fall a bit, so if you have a mix of government and corporate bonds, as in an aggregate bond fund, the price rise is attenuated by the corporate bonds, just at the time you want the volatility smoothing effect and more money to rebalance into stocks. In 2008 intermediate term government bonds went up 13% and corp bonds went down about 5%. Anyway, not a big deal, just food for thought, and in the interests of simplicity sticking with a single aggregate bond fund is probably a better choice.

    1. Thanks Grant. That is a really interesting point about government vs corp bond behaviour during a meltdown. You have taught me something new yet again – I love it! I can have a look at BXF later this morning after rounding and post it in the comments section. Should be simple now that I figured out the factors involved – it took me a while to wrap my head around RDTOH and GRIP also. My eyes honestly glazed over whenever my accountant mentioned them, but now they seem more important with deciding how to invest and pay myself via my corp. Seems we can work around the new rules, but more complicated. Incorporated professionals will need to have an idea about it in case their portfolio planner and accountant are not connecting the two moving parts (common problem I think).

    2. This was pretty interesting. Strip bonds carry different risks and you are using them to diversify further against risks, but the risk premiums were easy calculate using the same methodology. I’ll have to do a full post another time to talk about strip bonds more fulsomely down the road.

      Anyway, for a corp account that is below the SBD threshold, after tax, BXF would give 1.36%/yr without release of RDTOH and 1.73%/yr with RDTOH. So, using RDTOH, BXF is 0.69%/yr less than HBB and 0.31%/yr less than VDB.

      For a corp account over the SBD threshold where passive income bumps the active income tax rate: Without using RDTOH and GRIP, BXF comes out at 0.54%/yr which is 1.88%/yr less than HBB or 0.24%/yr less than VDB. However, when you account for triggering all of your RDTOH and GRIP, the return of BXF is improved to 1.29%/yr. That is 1.13%/yr less than HBB and VDB/BXF are basically even to each other.

      Looking at their historical distributions, BXF has also made some significant “returns of capital” which would be tax-free. Seems to vary so I couldn’t model it, but that is pretty cool and would help out BXF’s return a bit.
      -LD

      1. Thanks! Although one thing to note, if I understand your methodology correctly, BXF and ZDB (and HBB) have significantly different durations, so will have different yields and expected total returns based on that alone, regardless of other factors, BXF being a short term bond fund and the other two being intermediate term bond funds.

        1. Yeah. It is a bit of an apples/oranges comparison I think and I couldn’t figure out how to resolve some of that. In the end, I am not sure how much comparing one to other really matters since they are being used to accomplish different purposes anyway.

          1. Another way to look at this is tax efficiency or tax cost ratio as Justin Bender describes here. Also (see comments section) to use GICs to compare bond funds of different durations. Eg. For HBB compared to a 5 year GIC, currently yielding 3.5%. The after tax yield for HBB is 2.66-0.09-0.15 x (1-.25) = 1.81%, compared to an after tax cost of a 5 year GIC of 1.75% – not much difference, but ignoring the tax deferral of HBB. Of course, GICs and bonds are different animals and you do need some bonds for rebalancing purposes. I actually have 12% bonds and 28% GICs (60/40 stock/bond mix) which will give me enough bonds to rebalance a 50% equity crash.

            https://www.canadianportfoliomanagerblog.com/bxf-tears-a-strip-off-competitors/

          2. Mark, could you elaborate on what you mean by BXF and ZDB being used to accomplish different purposes? Sure, they have different durations so will have different volatility, but they both still have the same primary function of diversifying equity risk.

          3. What I mean is that BXF and ZDB are being used to diversify within fixed income by being structured differently from one another (if I understand your intent in separating your credit risk and term risk). So, one having a little more yield than the other (estimated by my risk premium) isn’t so much the point as that they are different. Of course, as fixed income, together either is basically being used to smooth out volatility from equity risk.

  3. Very helpful comparison, LD!

    I think the tax change doesn’t apply until 2018 corp year? So we can rebalance this year without affecting the threshold? I may need to trigger some gains given the elevated valuation and trumps upcoming trade war.

    1. Hey BC Doc! I have been gradually reducing some US exposure to rebalance also. I am keeping an eye on the threshold. My understanding is that 2019, the new active income threshold comes in, but that it is based on the 2018 passive income.

  4. Thanks for doing all this work LD!!! I am getting googly eyed reading all this and I still haven’t figured it out yet. I have never bought a bond fund yet but am still thinking about ZDB when my GIC’s mature.

    Maybe best to just keep my fixed income in my RRSP’s and TFSA since this is all getting rather confusing….

    My brain cells are NOT keeping up with your blogs!!!

    1. Not sure that mine are either 🙂 I am only just building up my fixed income piece and it will all fit in my RRSP/TFSA fortunately. I figured that I’d take on looking at these ETFs since there has been a lot of talk about them recently. It has turned out to be way more complex than I realized it would. There is nothing wrong with a simple approach – especially when the big things like earning enough, saving enough, and spending on things that matter are in place.

  5. Hey LD,

    So I read your article (HBB vs ZDB) with interest, and was wondering if you provide any personalized financial consultation.

    Please let me know.

    Thanks.

    1. Hi Nagib,

      I am a physician and not a professional advisor. However, I am happy to give my two cents worth in helping colleagues out for free as a “financial mentor”. I can stick to simple things with the understanding that my opinion may be worth less than the price charged 🙂 I will email you.
      -LD

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