Saving Cash: ZST Bond ETF vs CASH ETF vs GIC After-Tax

With interest recently rising, people have been parking cash in high-interest savings accounts (HISA), HISA ETFs, and GICs. I previously detailed these options for saving for short-term needs and why you must invest for the long term. High interest sounds great, but it often comes with high taxes too. How much money you have left after tax is what you have available to spend. This post compares ZST (ultra short-term bonds) vs HISA vs GIC as options to park some cash in tax-exposed investment accounts.

Many people seem to obsess over which fund, account, or GIC pays 0.1%/yr more between providers. However, choosing between the product types could make a 0.8-0.9%/yr difference in how much money you have in your pocket after taxes. Consider whether an ultra-short bond ETF, HISA ETF, or GIC might be best for you.

GIC HISA ETF

This is not an apples-to-apples comparison. Different saving options come with different potential benefits and risks. So, you must consider how the conveniences and potential risks apply to your situation.

One of the disadvantages of using ETFs compared to a bank account or GIC is that you do need to have an investment account that can hold ETFs. Most high-income investors must invest beyond the space allowed in their RRSP or TFSA anyway. That requires a personal or corporate investment account anyway. So, that is why I chose two ETFs and a GIC for comparison.

A HISA at a bank would have CIDC coverage and a slightly higher interest rate compared to a HISA ETF. A GIC would be the same if held directly or in an investment account.


ZST and ZST.L are ultra-short-term bond ETFs

ZST is BMO’s Ultra Short-Term Bond ETF and ZST.L has the same holdings, but automatically re-invests the interest for you. There are other ultra-short-term bond ETFs out there, but automatic re-investment is an important advantage to avoid the drag of cash sitting around or transaction fees to invest it.

Because the ZST ETF invests in bonds, there are some risks. There is creditor risk. However, three-quarters of the bonds held are government bonds. The other 25% are investment-grade corporate bonds (think banks and major companies like Bell Canada). So, the risk of default is minuscule. Especially over the short time frame. The average weighted duration of the bonds held is only 4.6 months. That duration also indicates how sensitive the bonds are to changes in prevailing interest rates. Ultra-short-duration bonds are less sensitive than longer-dated bonds, but if interest rates rise further, then their price could drop. If interest rates drop, their price could rise.

Currently, because interest rates rose rapidly last year, ZST holds many discount bonds. As detailed in the last post, discount bonds can improve tax efficiency. More of their return is paid out as capital gains instead of interest. Capital gains are much more tax-efficient in personal taxable or corporate investment accounts.


CASH.TO is a HISA ETF

High-interest savings account ETFs, like CASH.TO, park cash in a bunch of different HISAs at Canadian financial institutions. In addition to a small management fee from the ETF provider for doing that, the banks will offer a slightly lower interest rate. That is because OSFI requires the banks to hold more collateral than they do for regular depositors as of Jan 31, 2024.

That will likely translate to a ~0.5%/yr interest reduction compared to direct HISA deposits as it is phased in. Interestingly, some of the high-interest ETFs are changing in response to take a more money market approach – like holding short-term government bonds and high-quality corporate bonds (like ZST) to try and boost yields. CASH.TO hasn’t done that – so is a good comparator.

The other important difference between a HISA ETF and a HISA is that there is no CDIC insurance for HISA ETF deposits. The counterpoint is that the ETF spreads risk by depositing at multiple institutions. It is likely a moot point since the collapse of a major Canadian bank is unlikely and would come with overarching financial chaos regardless of where your money is.


Guaranteed Investment Certificates (GICs)

You can buy a GIC from various financial institutions that range from major banks to smaller operators listed on the internet that I’ve never heard of. Nerdwallet tracks the best GIC rates nicely. There is no free lunch. Smaller operators pay higher interest rates because they have a higher risk of default. It is still usually miniscule and may be covered by CDIC, provincial credit union insurance, or some other collateral. Some GICs will have larger minimum required purchases.

The biggest risk of a GIC is liquidity. You lock your money in for a defined period of time. For this comparison, I will use one year. You can get shorter-term liquid GICs. Again, no free lunch. There would be reduced interest and potentially extra costs for the ability to get your money back. GIC issuers could simply refuse to return your money before maturity. Even if you die.

The other tax issue to be aware of with GICs, besides that interest is taxed at higher rates than capital gains or eligible dividends, is that you may pay tax before you get the money. You don’t get the cash until the GIC matures, but the tax on the interest for each year is due annually.

I am using the most recent data from Feb 3, 2024. As expected, ZST has the highest gross expected return since it also has slightly higher investment risks embedded in the bonds compared to a HISA or GIC. The gross return, pre-tax net return, and income type mix are shown below.


Pre-Tax Gross Return, Fees, & Income Mix

For the gross total return of ZST, I used the average weighted yield to maturity of 5.38%. That is the expected interest paid until the bonds mature plus the capital gain. There would be a capital gain due to the bond purchase prices being lower than the face value returned to the bondholder when it matures.

A capital gain or loss on top of that could happen depending on prevailing interest changes between now and selling the ETF. However, that is unpredictable. The average weighted yield to maturity and bond coupons will also change over time as bonds mature and new bonds replace them in the ETF portfolio. However, the current data is a good snapshot at this point in time.

The gross total return for CASH.TO was 4.91% from Horizons’ ETF info page. For a benchmark GIC, I used a 5% interest rate. That was the highest rate from a major bank.


After-Tax Return of ZST vs CASH vs GIC

To illustrate how the income for each option would be taxed, I break it down in the table below. It uses the top Ontario marginal tax rate of 53.53% for interest income. Capital gains are taxed at half that rate. The management fees for ETFs are subtracted from the interest. This is how they function. Distributions are net of fees and interest net of the fees is what is taxed.

As you can see, the fact that ZST under the current market conditions has a distinct advantage, after taxes are accounted for. That will become less so if interest rates decline and fewer discount bonds replace the maturing ones. However, declining interest rates would also boost bond ETF prices. Slightly in the case of ultra-short-term bonds. The advantage also becomes less if you are more lightly taxed. Although, if you have a lower income, then even small differences may still matter to you. I show ZST’s current advantage at different income levels below.

A Canadian Controlled Private Corporation (CCPC) is another common investment option for business owners. It allows for tax-deferred investing. However, interest income is not treated kindly when you factor in the corporate tax and personal tax to pass it through for personal spending. Capital gains are much more favorably taxed. So, the current mix of discount bonds in ZST makes it an interesting option for parking some corporate cash short-term also.


Relevant CCPC Tax Basics

Corporate taxation is complicated. Basically, investment income is taxed at close to the highest personal rate up front. To prevent unfair advantages. However, some of that tax is tracked by a notional account and refunded to the corporation. That Refundable Dividend Tax on Hand (RDTOH) is about 31% of original interest income and is refunded to the corporation when non-eligible dividends are paid out to the owner (and personal taxes paid). Capital gains are also tracked by a notional account and the non-taxable half of the gain can be paid out as a tax-free capital dividend.


The ZST Advantage Flowing Through a Corp Account

With tax integration, the magnitude of the advantage of ZST over the other alternatives in the model is similar to personal accounts. However, the overall amount of cash in hand is less for all options. As I mentioned, tax integration is not kind to corporate passive interest income. However, tax deferral is an advantage. It is worth mentioning that the tax-free capital dividend could be used instead of some salary or taxable dividends to enhance tax deferral. I described that mechanism of using the CDA for tax-deferral previously in a post about corp class ETFs.

The advantage of ZST and ZST.L is currently pretty amazing if you are looking to park some money for the short term in a tax-exposed account. As long as you understand why and accept the underlying risks. Longer term, I don’t think this opportunity will last. However, longer-term I also think money should be invested rather than saved anyway. Some of the advantages may persist. Others may not. There are also a couple of other options with slightly higher risk exposures.


Higher Expected Returns & Liquidity Advantage May Persist

Some of that is because there is some extra risk to using bonds rather than a HISA ETF or GIC. That said, they are ultra-short-duration. So, the interest rate risk is small, and the risk of default miniscule. That contribution to the advantage should persist. However, the tax efficiency advantage will shrink as the amount of discount bonds in the ETF shrinks. Conversely, the advantage vs a HISA ETFs may widen as the recent OSFI regulations hit them. Still, I do like the ETF liquidity compared to tying money up in GICs. I always seem to spend it before I had planned and need access.


Tax Advantages May Shift

ZST is currently stacked with discount bonds that were bought in a rising rate environment. As interest rates stabilize, and the ETF portfolio turns over there will be more of a neutral capital gain/loss opportunity. If rates start dropping again, then the coin could even flip. If ZST starts to be dominated by premium bonds, then it will become less tax-efficient. The capital loss baked into premium bonds does not make up for the higher interest payments when you factor taxes in.


Other Tax-Efficient Alternatives to Consider

There are a couple of other options that I didn’t put into this analysis because they have some other wrinkles.

One is the corporate class HSAV.TO ETF. Its corporate class structure essentially converts all interest to capital gains that are only realized when sold. However, that does come with some unusal risks. If Horizons’ fund corporation realizes net income, it gets taxed punitively. So, there is some management risk. That management is probably why HSAV was quickly closed to new subscriptions. As it result, it also sells at a 0.5% premium to its net asset value. So, if it were to close then there could also be a loss from that.

Another alternative, if considering parking cash for a bit longer would be ZSDB. It is a short-term discount bond fund. While ZST just happens to have discount bonds right now because the rate changes, ZDSB is managed to hold discount bonds regardless of the rate environment. So, it is more likely to have a persistent tax advantage. However, its weighted average duration is 2.6 years. That makes the price more sensitive to rate changes. Dropping interest rates would boost the price (an advantage). Rising rates would have the opposite impact.

Disclaimer: None of this is specific financial advice. I cannot recommend specific securities either – I am just illustrating an idea that I found interesting. I am a random dude on the Internet and not a financial professional. Do your due diligence and consultation with a professional as required for your situation.

9 comments

  1. Great post as always. Hey I thought the HISA’s DO qualify for CDIC? From my discussions with BMO, the underlying investments at the bank are CDIC insured.

    1. If you put money into a HISA directly, it is covered. If you are putting it in an ETF that then puts it into a HISA, it is not covered by CDIC. An institution (like the ETF provider) doesn’t get CDIC coverage and would exceed $100K pretty quickly even if they did. The bank regulators have also recognized that with the massive amounts of money being moved for a HISA ETF deposit/withdrawal that (in theory) could be removed by an ETF closure or mass withdrawal means the bank must have more collateral on hand. So, there is also going to be a lower interest rate paid to HISA ETF deposits than individual ones too.
      Mark

    1. Yes, thanks for pointing it out. BXF would be an interesting comparison for something like ZSDB. Tax-efficient, but a bit more interest rate risk due to the longer duration. The average weighted duration for BXF is just over 3 years. Holding strip bonds, I would think that it would translate into more price volatility. My main reason to hold bonds is to decrease volatility which is why I haven’t really used them.

      The underlying assets are pretty much all government bonds. So, a bit less risk and yield. Current yield to maturity of 3.18% for BXF and 4.27% for ZSDB (which has a larger helping of investment grade corporate bonds that juices the yield by adding some risk). Would be interesting to compare them after tax (accepting they are slightly different risk profiles).
      -LD

  2. Great article. Thank you for compiling all the info and teasing out the trends and implications in a clear, digestible manner.

    I have been trying to dig into the species of the mechanics of the ZST fund, but it’s tough to find exact explanations and data that makes sense to me. I have just wondered about how ZST specifically distributes the interest income and the return of capital. On many websites (for example quotemedia.com), it is reported as “monthly cash distributions.” There seems to not be a breakdown of ROC vs interest info easily found. For ex-div date May 27, 2022, the distribution was reported as 7 cents, and for ex-div Nov 28, 2022 it was 18 cents at quotemedia. Interest rates rose a lot in 2022, so this trend seems logical.

    I couldn’t easily find info on BMO websites. I downloaded the CDSinnovations.ca excel sheets for the T3’s for 2022 for ZST.TO. It looks like the ROC (box 42) and the investment income (box 26) are the same for every month in 2022. The numbers in 2021 are different than 2022, but again they are reported to be the same for each month of 2022. This makes me wonder if this info is incorrect given how much the interest rate moved in the year.

    So I’m wondering what is the methodology for the ETF to slice up the interest and ROC. Would it be sliced up monthly just exactly as the underlying holdings spit it out, or is there there some sort of annual averaging. Would someone who holds the ETF only in Dec 2022 get the same sized chunk of the ROC pie as someone who held it only in May 2022 or only in Jan 2022? Is it possible to get caught with your pants down with ZST if you happen to not hold it when the ROC is assigned?

    Can you advise a website where reliable data shows the historical numbers that would populate the t-slips?

    ZST does sound like a cool product! When you look at a website like Morningstar and it shows annual returns for each year, do those returns seem to accurately reflect the return that would have been achieved pre-tax by adding the ROC and interest? Or does this unique product mess up all data for most financial websites?

    1. Hey Diego,

      Good questions. The annual returns should be total return (interest plus capital gain) although I can’t vouch for the accuracy of various sites’ data. Great question about the mechanics of when distributions are made. I have always struggled to find that info too! I will contact and ask BMO ETFs about ZST specifically. I think of return of capital as the most tax efficient distribution there is. No tax. But, it does mean some tracking for taxes for when you sell.
      -LD

      1. I heard from my BMO ETFs contact already.
        ..many investors use ZST as a short term holding and investors are aiming to capitalize on higher short term yields, we handle ZST differently than other products.

        “ZST: Every distribution will include a combination of interest income and Capital gains (due to the crystallization of cg happening each month as bonds mature).”

        So, looks like it happens each month as a mix of interest and capital gains. Which is good from a tax efficiency standpoint.
        -LD

    1. Thanks Mike! This question comes up all of the time for significant amounts of cash – particularly for business owners planning their cash flow buffer. Using a discount brokerage account and a more tax-efficient product than a bank HISA could make a big difference to the bottom line.
      -Mark

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