People often think of interest payments when they think of bonds. However, bonds’ most important role in a portfolio is managing risk. A duration-matched bond could be used to hedge against a known future liability. A bond ETF could be used to diversify creditor risk by using many bonds. It also provides diversification away from equities in a portfolio, decreasing volatility and the behavioral or sequence risk that comes with it. Bond ETFs can provide those benefits but with more tax-efficient returns than interest payments. In a personal taxable account, ZDB and HBB are two tax-efficient bond ETFs. Learn more about how they compare to each other and a regular bond ETF.
Bond Basics
Premium vs Discount Bonds
The interest payment from a bond is called its coupon. However, bonds also fluctuate in capital value (price) before maturity. That value on the secondary bond market fluctuates inversely to the current interest rates.
Bonds with coupons higher than the current prevailing interest rates have more capital value when bought and sold on the secondary bond market.
In other words, bonds with higher coupons command a premium and are called “premium bonds.” Those with coupons lower than the prevailing interest rates are “discount bonds” and have a lower price. I previously published a more detailed article about discount bonds, with some pictures, if you want to learn more.
Capital gains and losses for bond value.
The price that a bond is originally purchased for is called the par value. For example, you could buy a newly issued $100 bond that matures in five years. When those five years are up, the bond is worth $100 (its par value).
If, instead of buying that newly issued bond, you bought it on the secondary market, the price may be different. For example, if the prevailing interest rates are lower than the bond coupon, you would pay over $100. Let’s say $105 for simplicity. A premium bond. When that bond matures, it is worth $100 dollars (par value), and you realize a capital loss of $5. Conversely, if you bought a discount bond for $95 with a par value of $100, you would have a $5 capital gain when it matures.
Discount bonds are more tax-efficient.
Since capital gains are taxed at half the rate of tax on interest income, discount bonds are a more tax-efficient way to hold bonds in a tax-exposed account. Two bonds can have the same total return (capital gain/loss plus interest received), but different after-tax values depending on the mix of capital gain/loss and interest income.
Estimating After-Tax Return of Bond ETFs
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.
When analyzing a bond ETF, I use the average weighted coupon and the average weighted YTM. The difference between those two would be the expected capital gain or loss. An important limitation of that is that the bond portfolio of an ETF is constantly changing as bonds mature and new ones replace those. However, this gives a useful snapshot. I compared ZDB vs ZAG last year, and Justin Bender also did a detailed analysis a few months ago. We both came to the same conclusion. With comparable risk/return, ZDB offers a slightly higher after-tax return of about 0.25%/yr. A rare free lunch.
For the rest of this post, I will use the best conventional ETF option (ZDB) and compare it to HBB, a swap-based ETF within a corporate-class structure. That structure introduces additional potential risks and benefits.
Corp Class ETF Basics
Mutual Fund Corporation vs Trust Investment Income
A corporate-class ETF has a structure different from that of conventional ETFs. The corp class ETF is one share class in a mutual fund corporation. So, the income from that ETF can be offset by expenses in other ETFs in the corporate family. If the net income across the MF corporate family of funds is zero, there is no tax. Instead, the value of each ETF unit value rises by the amount of its net income. So, for the HBB ETF, interest income effectively becomes a capital gain.
Similar to ZDB, that capital gain makes the ETF more tax efficient. However, there are a couple of important differences. ZDB realizes and passes through capital gains each year as bonds mature or are sold. In contrast, the capital gain for HBB is only realized and taxed when the ETF is sold, boosting tax efficiency and tax deferral. However, that also hinges on the MF corp not having net income attributed to HBB — a hidden tax risk.
Mutual Fund Corporation Tax Risk
The other feature of an MF corp is that losses from previous years are carried forward and used to offset future income. In the case of Global X, they booked a large loss pool during the 2020 market swoon. Since then, they have had more income than expenses each year, which has caused the loss pool to shrink, but they have still not had net income.
The trouble occurs if there is net income inside the MF corp. If that happens, it is taxed at the business tax rate, which is 39.5% in the case of Global X. That tax paid within the corporation would be assigned to the ETFs that contributed to the net income and reduce their share value. When you sell, the total of that hidden tax plus your personal tax on a capital gain is higher than interest or capital gains from ZDB would be.
How big is the corporate class risk?
So far, there seems to be a significant loss pool before the corporate tax breaks HBB’s tax efficiency. However, you can only see the loss pool update for the preceding year when Global X issues its year-end report for the ETFs each spring.
If there is net income assigned to HBB, then it quickly becomes less efficient.
That said, Global X has made some changes this year that may help keep the party going. Global X changed up its all-in-one ETFs (HEQT and friends) to use more conventional ETFs instead of the corporate-class ones. That may decrease income growth (but also decrease ETF return). They have also increased their swap fees as of Jan 1st, 2025, which increases expenses.
Another important nuance is how income is generated due to swaps. Global X would mainly settle swaps to control counter-party risk or if it is advantageous to book losses. The counter-party exposure for HBB is low (8.4% as of writing this) and would be expected to grow slowly, given that bond ETFs are slow growers.
I suspect that Global X would initiate a transition into a conventional structure if they saw trouble coming. However, there is always a risk of error. There would also be the management question of how to handle all of the unsettled swap income.
Comparing HBB ZDB ZAG Bond ETFs
The preceding sections described how bond returns are taxed and some of the specific risks associated with HBB’s structure. This section will provide some more direct information to compare how the bond ETF options may function to diversify and stabilize a portfolio. If they are roughly equivalent, then the fee and tax savings become a more important distinguishing feature.
Bond Market Index Holdings
Global X’s HBB ETF uses a swap contract to track the Solactive Canadian Select Universe Bond Index (Total Return), a broad index of Canadian government and investment-grade corporate bonds. The index rebalances quarterly with new issuances and recently had ~1700 holdings.
BMO’s Discount Bond ETF (ZDB) seeks to track the FTSE Canada Universe Discount Bond Index. It most recently had 403 holdings. BMO’s Aggregate Bond Index ETF (ZAG) tracks the FTSE Canada Bond Universe Index. That is a broader index with ~1700 holdings since it doesn’t target discount bonds specifically. So, ZAG is more comparable to HBB in terms of diversification. However, how much that adds is questionable, and ZDB is more comparable from a tax efficiency perspective.
While the Global X site provides a more detailed breakdown of corporate bonds, both HBB and ZDB allocated similar amounts to federal and provincial government bonds as their dominant holdings. The creditor profiles of ZAG and ZDB are almost identical.
Comparative Average Weighted Duration
The three bond ETFs may have similar creditor risk due to the bond issuers’ identities. However, as mentioned earlier, bond value is also impacted by fluctuations in prevailing interest rates. A bond has a fixed coupon, so the longer it is exposed to those market conditions, the larger the impact.
The bond duration describes the remaining sensitivity to changes in the prevailing conditions. It is actually based on the remaining interest payments pending before maturity. The duration acts like a shifting fulcrum for a catapult, as shown below.
So, longer-duration bonds carry more risk and have more price volatility – all else being equal. For comparison, HBB’s underlying index has a weighted average duration of 7.5 years versus 7.2 years for both ZDB and ZAG.
Comparative Fees & Costs
HBB has an MER of 0.10%/yr. Trading costs due to the swap contracts are also added to that. Previously, they were up to 0.15%/yr but were recently raised to 0.3%/yr. For the analysis, I will assume trading costs of 0.3%/yr for a total fee drag of 0.40%/yr. ZDB also has an MER of 0.10%/yr, and the trading expense ratio was 0.00% on its most recent factsheet. ZAG had a marginally lower MER of 0.09%/yr.
Total Return (Interest & Capital Gain)
I used the weighted YTM as the expected total return (income & capital gain). The distributions for ZDB and ZAG are a combination of interest from the coupon and any realized capital gains. The fees are subtracted against the more tax-inefficient interest income first. So, the distribution is interest minus fees plus any capital gains. For HBB, the yield and net capital gain/loss minus the costs is added to the net asset value. That translates to a price increase and unrealized capital gain. This is summarized below using January 2025 data.
Above is the pre-tax income. Bond ETFs will also fluctuate in price based on changes in market conditions (eg. interest rates or inflation expectations). That is unpredictable, goes both ways and would impact the different bond ETFs similarly. So, for analysis I have kept those other price fluctuations at zero.
Tax Efficiency of HBB vs ZDB vs ZAG
Passing Through All Gains Annually
Generally, capital gains are attractive because they are taxed at half the usual rate compared to interest. That is the obvious appeal of corporate-class ETFs.
If HBB shares were sold every year and tax paid on capital gains, that lower capital gains rate would result in less tax for HBB versus its conventional competitors. However, at the lowest personal tax rates, the higher cost of HBB overpowers that benefit. At higher marginal tax rates, the tax due to some of the income being interest (ZDB) and most of it being interest (ZAG) is worse than the additional 0.3%/yr swap fee. This is shown using Ontario tax rates below. Discount bonds (ZDB) have an advantage over ZAG in all tax brackets, but HBB’s net advantage is about double at higher tax brackets.
Tax Deferred Growth
A lower taxable income is only part of the advantage of capital gains. The conventional bond ETFs will pass through some capital gains each year, but HBB only does that when sold. Since that tax is not due until the ETF is sold and the capital gain is realized, HBB has tax deferral potential. Tax deferral is generally advantageous because the money that would have been paid as tax stays invested and compounds. This is why it doesn’t usually make sense to sell the ETFs and realize gains before you have to.
The growth boost from deferring HBB’s capital gains compared to the conventional ETF options is shown below. That is an annual advantage that compounds each year until the ETF is sold. It is also pre-tax. There will be capital gains tax when sold. We’ll explore its impact in the next section. Since ZAG has a high annual taxable distribution, HBB has substantial tax deferral compared to it. The tax deferral versus ZDB is also substantial as capital gains are passed through.
After-Tax Value In The Future
After-Tax Value When You Do Sell
The taxes on tax-deferred growth eventually come due. When sold, the extra capital gains for HBB that accrued (instead of distributions) will be partially taxable. One of the risks with ETFs is that you may be forced to realize the capital gain earlier than you’d planned if the ETF gets liquidated. Usually, that is a low risk if you stick with popular broad ETFs from major providers. Global X is a major provider, and this is a popular ETF. However, it is not inconceivable that there could be a problem with corporate-class income management,
To quantify the advantages and risks, I modeled how much more money you could have after-tax if you sold at different points in the future. The higher your tax bracket now, the more of an advantage HBB would have. Deferral of the extra capital gains tax further into the future also helps.
HBB vs Conventional Bond ETFs (ZDB & ZAG)
The chart below shows the increased after-tax value due to the HBB vs ZAG ETF over time. The illustration below uses a taxable income of $125K in Ontario, both now and in the future. An income level where HBB could make sense. Tax on the distributions is removed annually for the conventional ETFs. The value at each time point is after the capital gains tax from liquidating the ETF. As you can see, there is a small increase in the amount of after-tax money that grows over time. About 2.28% more after-tax money at 10 years, and 3.7% at 15 years. Less if the capital gain is taxed at a higher inclusion rate of 66.67%. Importantly, even if forced to sell after the first year, HBB came out ahead.
The HBB advantage is slightly narrower when compared to the reasonably tax-efficient ZDB discount bond ETF. Still, HBB came out ahead after even one year. It had left a little over 2% more after-tax money at year 15.
Impact of Different Future vs Current Income Tax Rate
The benefit of tax deferral is also impacted by the current vs. future tax rate. If you defer from a high current to a lower future tax rate, the benefit grows. The reverse also applies. For example, deferring from a low tax bracket now and realizing a large gain that bumps you up the tax brackets later could be detrimental. HBB is likely to grow slowly, which is the nature of a lower-risk bond ETF. So, a massive capital gain is less of a risk than with the equity ETFs.
Compared to a conventional aggregate bond ETF, HBB’s tax deferral advantage magnifies the after-tax return if deferring from a high to middle tax bracket. In this model, 5-6% more money depending on whether the capital gains inclusion rate increases in the future. If tax deferral was working against you, deferring from a middle to a high future tax bracket, HBB still comes out ahead. However, if the capital gains inclusion rate also increases, there could be a sub-optimal outcome over a short time horizon.
ZDB has more capital gains than an aggregate ETF like ZAG. However, that tax liability is removed each year as the tax is paid on distributions. HBB’s capital gains tax liability is deferred to the future. Compared to the discount bond ETF (ZDB), HBB’s tax deferral advantage to a lower future tax bracket was still substantial: 3.5-4% more money in hand. However, if the future capital gains inclusion rate were higher and you were in a higher future tax bracket, it would be easy for HBB to leave you with less after-tax money than using ZDB.
Risk vs Reward: HBB vs ZDB vs ZAG
Whether to use HBB or a conventional ETF is a personal decision. I cannot give specific investing advice. Hopefully, this post will help you to make a more informed one as part of your own due diligence. It is a balance of potential risk and reward. In a tax-sheltered account, like an RRSP or TFSA, it is easy. The cost of a corporate-class ETF is not worth it. In a taxable personal account, it depends.
HBB, ZDB, and ZAG have similar creditor and duration risks. Therefore, they should function similarly in dampening portfolio volatility. Those focused on “income” may want to use an aggregate bond ETF like ZAG. However, those who want the most money in their hands after tax would prefer either ZDB or HBB. I will focus the rest of my commentary on ZDB vs HBB.
Potential Reward
The potential reward of using HBB rather than ZDB is small at moderate income levels but could add up over longer time periods. However, a lot can happen over time. The recent increase in the swap fee is a good example. If you defer from a lower current tax rate to a higher future one, that would also nullify the benefit. It may even be mildly detrimental if the timeframe is short and taxes rise.
The potential advantage is greater in the highest tax brackets, and the risk of being bumped into higher tax rates is also lessened. Taxes can only go so high. Supposedly. They have been higher at different times and in different parts of the world.
Potential Risks
The unknown future is where risk can materialize. We expect that there is investment risk with equities. However, the corporate class structure adds other risks. This analysis assumes that HBB has no net corporate income assigned to it from the corporate class structure. If there is net income, then it quickly becomes inefficient. Global X might be able to manage a conversion to a conventional ETF if they see that coming, but I am not sure how that would play out.
HBB has swap-based income. So, the risk of income is greater if they must settle swaps to manage their counterparty risk, which could happen with massive market rises. The counter-party exposure for HBB is very low (8%). Bond ETFs also do not usually grow rapidly enough to increase that unexpectedly. Of the different corporate-class ETFs in Global X’s family, the risk of unexpected income seems low for HBB.
The potential good news is that while the recent swap fee increase has made HBB less attractive, the increased costs may also make the corporate structure more sustainable. I’ve done my best to model what the benefits could look like and discuss the potential risks. However, the biggest risks are always the ones you don’t see coming.
Disclosures: We don’t currently use ZDB or HBB because we don’t have a bond allocation at present. However, I have used them in the past and will likely use them again.
I use HBB and HTB for bond exposure in my corporation. Recently I discovered IGB.TO which is a Purpose ETF which is also corporate class ie. shielding bond returns from the higher tax rates. IGB pays out distributions mostly as return of capital. It holds global bonds including IG, HY, CLOS resulting in an overall higher yield to maturity of 6.59% currently (although I wonder if this effectivly is partly reduced due to the currency hedging – current yield is 5.6%). MER is a bit higher at 0.55% but no swap fees that I know of. May be interesting to some looking at HBB and ZDB.
Thank Jeff.
It is an interesting option. A benefit would be more global bond exposure than HBB, and the CAD hedging also makes sense in that context. The fee is a bit higher than the MER/Swap cost of HBB. So, it would be trade-off between global diversification and cost.
The return of capital aspect also adds an interesting layer. The benefit would be that it is a way to gain access to some of the value regularly while keeping the tax deferral going compared to selling some HBB and likely realizing a smallish capital gain. The downside would be having to track the ACB as it drops with each distribution. You could use DRIP to reinvest the money without extra effort, but the ACB would still change. I prefer to just take income when I want to and capital gains don’t bother me much, and I try to keep my ACB tracking tasks to a minimum. However, I can see the appeal.
Thanks for sharing this.
Mark