Editorial Note: Bonds can be confusing for people. However, they may play a vital role in your portfolio. The role is also often misunderstood. People tend to focus on the “income” of fixed income. In this post learn more about the role that bonds play, and how they give you a return on your investment. Unless you are going to use a complex asset location strategy, you may need to hold some bonds in tax-exposed accounts. Find out more about how discount bond ETFs can simply fixed-income investing in a more tax-efficient way.
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Discount Bonds & Your Portfolio
By: Danielle Neziol, VP, BMO ETFs, Online Distribution
Don’t call it a comeback. They’ve been here for years.
Discount bonds are not new. However, they have been making a comeback with recent interest rate changes. For the first time in almost a decade, fixed-income investors are enjoying the “income” part of the fixed-income equation. The Bank of Canada, in an effort to temper inflation, has set its overnight rate at 5% (as of Jan 2024) and it is this rate (often referred to as the “risk-free rate” or “overnight rate”) that sets the tone for the entire bond market. Therefore, this current interest rate environment has given fixed-income investors healthy-looking yields to support their portfolios. That is what grabs the headlines, but it is only part of the story. However, when deciding whether and how to use bonds in a portfolio, you must consider the role that bonds play and how their returns are taxed.
The Role of Bonds in a Portfolio
Investors use fixed income to reduce portfolio volatility, and of course, for consistent income streams. Bonds are generally less risky than stocks.
Managing Risk & Potential Return
In the investing world, we are compensated for taking on risk, and quite often the more risk an investment carries, the more potential for future gain, but there is also greater potential for future losses as well. A key understanding for investors is that when managing their portfolios, they need to manage their risk as well as returns. How much risk an investor can handle in their portfolio is unique to them and based on their portfolio goals and objectives.
When you buy a stock, its current price represents everything we know today about that company (all public information) and the market’s expectations for its success in the future. However, that future can be uncertain due to many unknowns impacting the company’s future prospects. The amount of uncertainty tied to each stock represents a risk to the investor. The primary role of equities in a portfolio is for growth.
Fixed income’s primary role in a portfolio is for risk mitigation. Bonds help dampen the overall volatility (price swings) of the portfolio. Higher volatility is harder to stomach as an investor and may even drive us to buy or sell at bad times. Those behavioral mistakes may decrease actual investor performance.
Consistent Cash Flow
Fixed income’s secondary role is to provide consistent cash flow. Most bonds provide stable interest payments to bondholders (coupons) and a repayment at maturity. Some investors desire these regular cash flows. That type of income may psychologically help them to feel secure, or it may be necessary to fund expenses in retirement. However, interest income is taxed when received outside of tax-sheltered accounts.
Bonds carry the risk of default (either on coupon payments or principal repayment, or both). Bonds have credit ratings which help investors identify which bonds might be more likely to default (high yield). In the event of bankruptcy, bondholders get first right to assets over equity investors, which helps their risk profile stay low. Therefore, bonds generally carry less risk than equities, but also have a lower expected return than their equity counterparts.
Taxation of Interest Income
For investors holding fixed-income ETFs in taxable accounts, the income paid out to investors from bonds is taxed as interest income. Interest is usually taxed less preferably than other types of income in Canada (such as dividends or capital gains). Fortunately, there are ways to manage this more efficiently from a tax perspective, and one way is to use discount bonds.
Discount bonds can help fixed-income investors manage their tax bills if they are holding these types of investments in taxable accounts. Investment advisors have been doing this for years. Finding and buying discount bonds may be challenging for the DIY investor. There are also liquidity and transaction cost issues for someone trading the over-the-counter bond markets. Fortunately, direct investors can access the same type of tax strategy using discount bond ETFs.
Interest Rates & Bond Prices
First, to understand why discount bonds can be helpful, it’s important to understand how the bond market works. When brand new bonds are issued, they are sold on the primary bond market. The price is the par value. That is what you pay to buy the bond and what you will get back when it matures, barring bankruptcy. The interest payments made along the way are called coupons.
Once a bond is issued, it can be resold on the secondary bond market before it matures. Prior to its maturity date, it can trade at different prices which are usually impacted by the current interest rate environment.
Bond prices and interest rates have an inverse relationship. So, when interest rates go up, bond prices go down. This is intuitive: when rates go up, new bond issues will reflect these higher rates, while older bond issues now seem less attractive as they are trading with lower coupons relative to the current market rate. Who wants a “gently used bond” paying 2% when you can buy a “shiny new bond” paying 5%?
Because prevailing interest rates have gone up so aggressively recently, bond prices have been dropping. This has created an environment where many bonds are trading at a discount to their par values. However, we also know that even though the price of a bond can move throughout its issuance, it always matures at par value, meaning if a bond is trading at a discount today, if you hold it until it matures, its value will be pulled back up to par by its maturity date. So, discount bonds are bought at a discount now and mature at full price – a capital gain.
Bond Coupons & Yield To Maturity
A bond can be issued with a fixed coupon. This is the annual interest to be paid to the bondholder until the bond matures. The coupon rate that is set at the bond’s issuance reflects the overall rate environment A risk-free bond is essentially priced at the Bank of Canada overnight rate. However, bonds have risks that are also priced into the coupon.
There is credit risk that the lender would take. For example, corporate bonds typically carry more risk than federal issues, and all else being equal have slightly higher coupons. The riskiest loans command high coupons for investors to take on the risk and are often called high yield bonds or “junk bonds”.
Also, the duration of the bond impacts the coupon. Longer-dated bonds typically carry more risk than shorter-term bonds because a lot more can happen along the journey to maturity.
The above factors influence the setting of the coupon rate when a bond is issued. Once issued, the coupon is a fixed rate and does not change.
Yield to Maturity
The yield to maturity, or YTM, of a bond is the bond’s internal rate of return, assuming the bond is held to maturity. This number changes over time as the bond gets closer to maturing. It reflects the bond’s present value vs its future (par) value.
Discount vs Premium Bonds & Bond ETFs
When the coupon rate (interest income) on a bond is less than its YTM, this is a good indicator that this bond is trading at a discount. We would call it a discount bond. You are paying a lower price now to buy the bond than its par value at maturity. If the coupon rate is higher than its YTM, then it is trading at a premium. You are paying a higher price now than you will get back at maturity, but there are higher interest payments along the way.
The same principle holds true for a fixed-income ETF (a portfolio of bonds). However, an ETF holds a whole portfolio of bonds in different amounts. So, a weighted average for the coupon or YTM of the bonds held is a more appropriate measure. When that ETF’s weighted average coupon is less than the weighted YTM, that ETF is effectively dominated by discount bonds.
Tax Efficiency of Discount Bonds
If a bond is purchased at a discount and held until maturity, the bondholder will receive two sources of income throughout the bond holding period: coupon payments (interest income) and capital gains.
The capital gains reflect the difference between the bond’s purchase price and its par value at maturity. So, if an investor were to purchase a $100 par value bond when it’s trading at $80, that investor will make $20 in capital gains once the bond matures.
Same Total Return: More capital gain & less interest income.
The net effect of a discount bond is that it keeps coupons (interest income) lower and adds capital gains into the distribution mix. This creates a more tax-efficient distribution for the end user. This helps a fixed-income investor who is managing a taxable account.
Discount Bond ETFs Make It Easier
Because the bond market is not as easily accessible as the equity market for direct investors, fixed-income ETFs have become the go-to solution for investors to easily add a bond portfolio to their investment accounts with the efficiency and liquidity of an equity trade.
The BMO Discount Bond Index ETF (ZDB) has become one of the largest discount bond ETFs in Canada.1 Investors use this investment vehicle as an efficient way to add a portfolio of discount bonds to their investment mix.
ZDB is an “aggregate bond” exposure. This means that it holds bonds that represent the entire Canadian bond market. This includes short-term, mid-term, and long-term bonds of federal, provincial, and corporate issues. Investors who want to take the guesswork out of fixed-income investing appreciate aggregate bond exposures for their diversification and ability to be invested in all areas of the market rather than pinpointing a certain area. Therefore, an ETF like ZDB can be viewed as a complete fixed-income exposure for anyone managing a fixed-income sleeve in their portfolio.
Discount Bonds Aplenty
Discount bond ETFs, such as ZDB, house discount bonds regardless of the rate environment and are accessible to investors whether rates are rising or falling. However, in a rising rate environment, the profile of many fixed-income ETFs have skewed to have a greater proportion of discount bonds within them. This goes back to the foundational understanding of bond prices and their relationship to rates. As rates rose throughout all of 2023, bond prices dropped. This has created a few more tax-efficient opportunities for fixed-income investors that didn’t exist last year. Below is an example of an interesting one.
Tax-Efficient Cash-Equivalent Opportunity
BMO’s Ultra Short-Term Bond ETF (ZST) is often utilized as a “cash replacement” ETF. Several features underpin that. Its bonds mature in less than one year. So, the duration2 risks are low. It holds corporate bonds from high-quality institutions (think Canadian banks and Telcos). So, the credit risk profile is also low. Since corporate bonds do have some risk, it can generate a slight yield pick up of about 20-30 basis points (0.2%-0.3%) over other traditional cash like ETFs (like HISAs or money market funds). As an ETF, it is also liquid and easy to move money in or out of.
But here’s a fun fact- ZST is holding 100% discount bonds right now (as of Jan 2024). Again, this is a direct reflection of the rate environment. All of the bonds in its portfolio were issued several years ago when interest rates were lower. Therefore, today their coupons are much lower than those on new issues. They are priced at a discount to their par value.
So, for investors looking for a spot to park cash equivalents in a taxable account, ZST (and other ETFs like it) have the added benefit of improved tax efficiency via exposure to discount bonds in the current market environment. Now, this won’t always hold true. When the rate environment changes the profile of the bonds in the portfolio will change. But for now, investors can hunt out discount bond portfolios where they couldn’t find them before.
Find Discounts For Your Portfolio
It doesn’t take a fixed-income analyst to figure this out. Direct investors can do their due diligence to consider the tax efficiency of the income and capital gain mix on any fixed-income ETF. Compare the coupon and YTM of the holdings. We have highlighted a couple of easily identified opportunities in this article. The ZDB ETF is managed to seek out discounts for you. The current environment has made ZST an opportunity for a more tax-efficient payment mix for short-term needs. Hopefully, the knowledge base from this article will help you. Use it to spot other opportunities as you look for ways to use bonds as part of your portfolio.
The key: if the weighted average coupon is less than the ETF’s weighted average YTM, this indicates that there are discount bonds in the portfolio. That shifts the total return composition away from interest-only to a mix of interest and more tax-efficient capital gains.
Fixed Income Portfolio Video
This post focused on discount bonds and the information needed to understand how they work. There were also some specific examples. For more information about the general approach to building a fixed income portfolio in another format, check out this video. There are also more videos and content at ETF Market Insights.
Commissions, management fees, and expenses all may be associated with investments in exchange traded funds. Please read the ETF Facts or prospectus of the BMO ETFs before investing. Exchange traded funds are not guaranteed, their values change frequently, and past performance may not be repeated. For a summary of the risks of an investment in the BMO ETFs, please see the specific risks set out in the BMO ETF’s prospectus. BMO ETFs trade like stocks, fluctuate in market value and may trade at a discount to their net asset value, which may increase the risk of loss. Distributions are not guaranteed and are subject to change and/or elimination. BMO ETFs are managed by BMO Asset Management Inc., which is an investment fund manager and a portfolio manager, and a separate legal entity from Bank of Montreal. This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Particular investments and/or trading strategies should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance. ®/™Registered trademarks/trademark of Bank of Montreal, used under license.
- Source: Morning Star Direct, December 2023 ↩︎
- Duration is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years. The price of a bond with a longer duration would be expected to rise (fall) more than the price of a bond with a lower duration when interest rates fall (rise). ↩︎