Horizon’s HBB Canadian Bonds Total Return Index (TRI ETF) could play a role in the corporate investment accounts of Canadian high income professionals.
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.
Introducing Dr. Sarah Connors – a mid-career high income specialist & moderate saver with average risk tolerance
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.
The 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%.
If 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…
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?
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?
As 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.
While 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…