ZDB ETF (Discount Bonds) vs Regular Bond ETF = Free Lunch

For the last couple of weeks, we’ve been exploring discount bonds. We explained how discount bonds work and how to identify ETFs with discount bonds in them. Last week, I showed how ZST/ZST.L currently have discount bonds in them, making for a tax-efficient way to park some cash for the short term. That is a time-limited opportunity because there just happens to be lots of discount bonds floating around right now due to recent interest rate increases. However, there is also an ETF that targets discount bonds in all interest rate environments. BMO’s Discount Bond Index ETF (ZDB.TO) specifically targets discount bonds. So, it is stuffed with them in both rising rate and lower interest rate environments. In this post, I will compare the potential after-tax returns of ZDB and a comparable regular bond ETF (ZAG.TO). Are the tax savings a big free lunch?

Free Lunches in Investing

A free lunch is one of the only things that makes me run faster than a “code blue”. Unfortunately, there are very few free lunches while investing. By that I mean you get paid extra without taking on extra risk.

Publicly traded markets are efficient enough that probable outcomes and risks to future cash flow get priced in. More quickly and completely than we can do as individuals. So, diversification is often touted as the only free lunch in investing.

By owning many holdings with similar expected returns, you reduce the volatility while still getting the same average return in the long run. You cannot predict which stocks will win or when, but you can diversify away uncompensated risk and go along for the ride.

Another reasonably predictable thing in life is tax. In this case, taxes on investment income. If you could get the same benefits to your portfolio, the same expected return, but lose less to tax – I would call that a free lunch too. I think that using ZDB (a discount bond ETF) instead of ZAG (a regular aggregate bond ETF) in tax-exposed parts of a portfolio is one of those rare free lunches.

To quantify that, I will compare BMO ETF’s ZDB.TO and ZAG.TO. They are easily comparable with almost identical risk profiles. You can also find other discount bond ETFs. However, ZDB has been around the longest, is the largest, and has the lowest MER.

ZDB vs ZAG To Manage Risk

The primary role of bonds in a portfolio is to manage risk. That is partly by reducing the overall investment risk. The future cash flows of bonds are more reliable than stocks. Bondholders are also higher up the food chain if there is a bankruptcy. Bonds also help to reduce volatility. Both because their prices are less volatile and because they have a low correlation to stocks. That is serious business because higher volatility is related to worse investor behavior. The average underperformance due to poor investor behavior is in the 1.5-2%/yr range. It could also be much worse in extreme cases. Importantly, not all bonds are created equal for this task of reducing risk.

Higher quality and shorter duration bonds are lower risk. So, when comparing ZDB and ZAG as options it is vital to compare their composition in that regard. Otherwise, you could be trading some tax savings for decreased efficacy in their intended role within your portfolio.

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ZDB and ZAG: Comparable Interest Rate & Investment Risk

As shown in the table above, these two ETFs are extremely similar in terms of fees, duration, and holdings. So, they should have almost identical characteristics for managing risk in a portfolio. The weighted average YTM of ZAG is marginally higher. Both ETFs currently contain discount bonds. However, that is much more prominent in ZDB with an average weighted coupon of only 1.94% vs 3.08% in ZAG. As expected. The pre-tax returns should be comparable, but the post-tax return is what will make it interesting.

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ZDB & ZAG ETF Historical Performance

With their very similar characteristics, you would expect their historical performance to be comparable. Unsurprisingly, over a decade, it has been. That decade spanned both rising and falling rate environments.

The volatility and correlations are very close which is what is important for their portfolio volatility-reducing capacity. Their pre-tax return favored ZDB ever so slightly. That has fluctuated back and forth over time by minuscule degrees. Post-tax has favored ZDB throughout those years, given its more efficient distribution mix that is heavier on capital gains and lighter on fully taxed interest. Let’s dive into what that should look like currently.

ZDB vs ZAG ETF in a Personal Taxable Account

Because ZDB is designed to target discount bonds, it is expected to have a more favorable mix of capital gains and interest. That is hard to pin down in the future because the ETF portfolios are constantly turning over. Bonds mature and are replaced by other bonds. However, we can use the weighted average yield to maturity and coupon to infer the expected interest and capital gains mix from the current holdings. As a spot check.

The weighted average yield to maturity is what the expected total return for the bonds held is. The weighted average coupon is the expected interest payment. So, the difference between the two is the capital gain or loss component of the return. When I last did this analysis in 2018, ZAG held premium bonds due to the long period of falling interest rates. That means they paid interest and had a capital loss. Currently, ZAG has discount bonds, but ZDB has even more. The comparative income mix of interest and capital gains is shown below.

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Tax At Top Ontario Personal Bracket

The top Ontario personal tax rate is 53.53%. That is applied to interest collected from the bonds in the ETF net of fees.

The capital gain is taxed at half the marginal rate.

When you consider the mix of interest and capital gains at the top Ontario marginal rate, the higher capital gains and lower interest payments of ZDB make for a 25 basis point (0.25%) advantage after taxes.

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The ZDB Advantage at Lower Tax Brackets

Applying the same methodology shows that advantage declines at lower tax burdens. No big shock. It remains a greater than 10 basis point advantage for those with incomes over $90K. At the lowest tax bracket, the tax savings are so marginal that a small difference in performance could negate the tax benefit. However, historically, ZDB has had a slightly better annualized return.

ZDB vs ZAG ETF in a Corporate Account

Taxation of passive interest income in private corporations is not kind. There is an upfront tax at approximately the highest personal tax bracket. About 50% in Ontario. Fortunately, 30.67% of the original interest received is refundable as RDTOH. So, the net corporate tax when running efficiently is 19.5%. However, there is still personal tax on the non-eligible dividends required to release the RDTOH and move the income out into personal hands. When added together tax integration does not favor moving interest through a corporation.

In contrast, capital gains can flow very efficiently through a corporation. Only the taxable half passes through the above layers of taxation. The excluded half of the capital gain adds to the corporation’s capital dividend account (CDA). That can be used to give a tax-free capital dividend to the shareholder. Capital dividends are one of the tax-efficient ways to move money out of a corporation. That could even boost corporate tax deferral if you can reduce the regular income paid by the corporation to fund personal consumption.

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The ZDB Tax Advantage in an Efficient Corporation

When you are paying out dividends from a corporation to live off of, the RDTOH is refunded as described above. That is as efficient as a corporation gets at flowing passive income through. The ZDB advantage in that situation is estimated below.

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ZDB Helps Mild Corporate Bloat

The above analysis was of an efficiently running corporation. However, if a corporation develops too much passive income relative to the amount of money the owners require to live on, it can become less tax efficient. I call that corporate bloat because it is not relieved until you pass some money out. It can happen from RDTOH trapping – when dividends aren’t needed personally and the taxes to give extra dividends are greater than just leaving the money in the corporation.

I repeated the analysis using a corporation with RDTOH trapping. In that situation, ZDB has a 0.31%/yr advantage in tax drag reduction. So, 0.31%/yr less drag on growth during the years until dividends are eventually paid out. At that point, the tax integration advantage from the previous section would apply.

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ZDB Helps Most Corps Over The Passive Income Limits

A corporation can develop severe bloat if it gets bumped over the passive income limits and the owners don’t move extra money out as either salary or eligible dividends. Only the taxable half of capital gains count as passive income. So, ZDB could help prevent or reduce corporate bloat compared to using a standard bond ETF, like ZAG. I detailed how the passive income limits can bump taxes in my comparison of HBB vs ZDB.

Basically, passive income over $50K rapidly reduces the amount of business income taxed at the low small business rate. That active business income is taxed at the higher general corporate tax rate. That is a big ~75% tax jump. However, it is attenuated by the fact the higher-taxed corporate income allows for some eligible dividends to be given. That saves ~8-10% compared to non-eligible ones. The net result is still a penalty for most provinces.

I will use Alberta as an example. Because it affects active and passive income, the result is reported as a drag on growth within the corporation. Interest income is penalized in this situation. That gives ZDB a 0.17%/yr growth advantage if the owner requires plenty of dividends to fund consumption. If the owner does not pay out dividends, then the penalty is astronomical. For ZAG, the tax is greater than the passive income received. ZDB is still bad with a 2.47% drag on growth. Of course, that is easily solved by moving money out of the corporation and paying personal taxes – the intent of the legislation.

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In ON & NB, ZDB Could Cut Either Way

Ontario and New Brunswick are a possible exceptions because their provincial governments did not mirror the Federal passive income tax penalty. If enough dividends are needed to live on, the passive income rules can result in a moderate corporate tax increase from the Federal general rate and low provincial SBD rate. That slight tax bump is more than made up for by personal tax savings from the eligible dividends generated. It still means that money must be moved out of the corporation (the intended effect), but it uses a carrot rather than the intended stick.

For Ontario, the bonus from the messed up tax integration counteracts the efficiency boost of ZDB in the corp. So, basically no advantage. If the corporate owner is not paying out enough dividends to make use of the eligible dividends generated by the anomaly, then the ZDB ETF has a decisive 2.39% growth advantage. Again, that can be narrowed by moving money out of the corporation to pay personal tax and use it personally.

In NB, a corporate owner caught up in the passive income limits, but spending enough dividends is better off with ZAG by about 0.08%/yr (data not shown). If not using the dividends, ZDB still comes out way ahead by 2.37%/yr.

Is ZDB a Big Free Lunch?

ZDB is extremely close in its returns, correlation to stocks, and volatility to an almost identical aggregate bond ETF. So, there is no penalty for using it instead in a taxable account to control the risk in your portfolio. I use personal money to buy my food. So, I would consider any boost to my bottom line after taxes are paid as a free lunch. The question is whether it is a whole Happy Meal^(TM), including a toy, or just some free dipping sauce.

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In a Personal Account

When using tax-sheltered accounts like a TFSA or RRSP, it doesn’t matter. However, for those of use saving beyond those accounts, it does. We must either use a personal taxable account or invest through a tax-exposed private corporation. While it is possible to overflow your registered accounts on a low income with a frugal spending, most people in that situation will have a moderate to high income. I suppose that people pinching pennies in a low tax bracket may still find a 0.05%/yr bonus exciting. However, the ZDB free lunch is much larger at higher incomes.

With a moderate income of ~$90K, there is a 0.10%/yr after-tax advantage in a personal account. That quickly rises to a 0.25%/yr advantage in the top tax bracket. That doesn’t seem like much, but a 25 basis point difference compounded over 30 years means about 10% more money. Without taking any additional risk.

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When Using a Corporation

The advantage for a corporation that is running efficiently is very similar. About 0.26%/yr in Ontario. However, interest counts towards passive income and only half of capital gains do. Keeping the corporate passive income down can delay or avoid the inefficiencies that arise from too much passive income relative to spending. If there is RDTOH trapping, the ZDB ETF allows for 0.30%/yr less drag on growth in the corporation.

If the corporation runs into trouble with the passive income limits to the small business deduction, then ZDB is a way to reduce some of the penalty without having to pay as much out of the corporation. Ontario and New Brunswick have anomalies that make a regular bond ETF as good or possibly better as long as the owners are moving a lot of money out of the corporation. If they decide to keep money in the corporation, then ZDB has a decisive advantage.

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Alternative Considerations

Some people may choose to hold their bonds as part of a bundled ETF. Like the asset allocation ETFs (ZGRO/XGRO/VGRO) or (ZBAL/XBAL/VBAL). They are a great way to invest and have the behavioral advantage of simplicity. For those with minimal tax burdens, the added complexity of using a 100% equity all-in-one (ZEQT/XEQT/VEQT) plus a second ETF for bonds (ZDB) may not be worth the effort. However, using a separate equity and bond ETF does make it easy to increase your bond allocation as you approach retirement and then spend it down again when outside the sequence risk window.

Another alternative for holding bonds in a tax-exposed account would be to use a corporate-class ETF (HBB). I compared HBB vs ZDB previously in a personal account and a corporate account. At low personal incomes, ZDB was better due to its lower MER. At higher incomes, HBB is better as long as there is no income in Horizons fund corporation. That is a management risk as they eat through their loss pool. The advantages are magnified in a corporation due to the favorable treatment of capital gains. However, the management risk remains. If you don’t understand or keep a close eye on the risks, then ZDB is a good alternative without taking on extra risk.