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” in their portfolios. Bonds or guaranteed investment certificates (GICs) provide less volatility and a more reliable income stream.
Those with large portfolios may need to hold fixed income in taxable accounts.
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.
Horizon’s Total Return Index (TRI) ETF that tracks the Canadian Bond Universe tracking ETF (ticker HBB)
Interest income, like from bonds or GICs, is taxed both immediately and unfavourably at your full marginal tax rate. Horizon’s corporate class structure, that includes HBB, allows the income to be offset by expenses elsewhere in the family of ETFs. So, no taxable income. That effectively translates into capital appreciation for HBB instead of income distribution. The amount of change should be more stable, like other bond ETFs.
That should have a similar impact on your after-tax bond returns as the introduction of sildenafil (Viagra) had on the drug prices.
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?
What premium from tax-savings could you expect to compensate you for the 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. A GIC 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.
They invest that money. 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, corp class HBB gives 0.44%/yr more after-tax return.
A GIC saves 0.32% compared to VAB, but your money is locked up in a GIC. HBB has a slightly better return than a GIC and it is liquid. You can sell and get your money at any time. Over a 25 year period, that premium would compound and result in a 12% larger account size using the corporate class 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.
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 after-tax increased return for using HBB 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.
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.
A small annual tax savings makes for a much larger portfolio over time.
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 and corporate class structure.
Inflation is also a risk over the long run.
We hold fixed income to reduce our risk of the money not being there when we need it. Having bonds also helps to smooth the volatility that provokes bad investor behaviour. However, 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.
Legislative risk of the Horizon 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. Update: they did take a swipe at the tax efficiency of the swap structure. However, that did not cause a shutdown. Horizon changed their approach to a more robust corporate class structure.
That said, for modelling, I will use a worst-case scenario. A forced liquidation and realization of capital gains. That tax event could cause you to pay a higher marginal tax rate than usual.
Can the swelling value of a taxable account with the HBB bond swap-ETF withstand a forced liquidation?
Let’s model some scenarios that will produce charts reminiscent of a Viagra advertisement.
Scenario 1: 20K/yr in a low income spouse’s taxable account with $100K invested in either HBB (swap) or VAB (conventional) ETFs.
- 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.
Scenario 2: The highly-taxed $250K/yr employee.
For a high income employee, HBB does seem to make a big difference. Growth instead of shrinkage of buying power. The longer that they can go before getting hosed by a cold tax-event-shower, the better.
The other problem with VAB in a taxable account.
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 countered by a capital loss. That is very tax inefficient because only half of a capital losses offsets the fully-taxed interest.
Why did I use VAB as a comparator?
I used VAB in this simulation because many people are drawn to the higher interest yield. That made for some really flaccid growth/shrinkage curves which suited the theme. There are more tax efficient ways to hold fixed income. I will move on to a “discount bond” fund (ZDB) for the next comparator to HBB in a corporate account.
- 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.