I wrote an article for “Moneyville” in the Toronto Star titled 6 places to get the best return for least risk.
In it, I briefly describe six sources of income:
- GICs: Plain vanilla
- Bond ETFs: The best choice
- Preferred shares: Also a good choice
- Common shares: Not Fixed Income
- Bond Mutual Funds: High fees
- Individual Bonds: Also a bad idea
Actually, Bond ETFs are only a good choice for non-taxable investors (RRSP or RRIF). Because they are stuffed with premium bonds, the after-tax returns are poor because the effective tax rate is 60% or more.
Example:
Consider XBB the i-shares DEX Canadian Bond Universe ETF at closing Oct 14:
Price = 30.33; Average Coupon = 4.69%; Yield to Maturity = 2.77%; Average Term = 9.17 Years; MER = 0.30%.
The pre-tax expected yield = YTM -MER = 2.47%
The weighted average bond price is approximately $115.45
Coupon Payments of 4.69%/1.1545 = 4.06% pre-MER or 3.76% of $30.33 after MER are fully taxed (e.g. 46% top Ontario rate) = after tax income yield 2.3%
HOWEVER, there is also an expected capital loss component of approximately the premium divided by the number of years (-15.45/115.45/9.17 = -1.46% per year (or minus 1.12% after tax IF capital losses are usable).
A more accurate calculation gives an all-in after-tax yield of 0.98% if capital losses are usable (an effective tax rate of 1-0.98%/2.47% = 60%). The effective tax rate will be higher if capital losses are not usable (offset against gains) or if OAS clawback affects marginal tax rates.
A worse case is short-term bond ETF XSB, which has an after-tax yield of 0.5% and a 71% effective tax rate!
Thus, in today’s world of low yields, bond ETFs are a gift to the tax man in taxable accounts.
A few other considerations for bond ETFs:
2. Broad Market ETFs hold a lot of federal debt (e.g. 45% Federal for XBB; 25% Provincial; 30% Corporate). Federal debt yields less than GICs at almost all maturities (especially after MER). An broad ETF owner cannot avoid holding federal debt. XSB is nearly 60% Federal or Agency debt.
3. Corporate bond ETFs hold at least 50% financial firm debt. Prefs are also concentrated even higher in financials, so the pref share investor who buys corporate bond ETFs is not substantially diversifiying her default risks by remaining highly concentrated in one industry.
As another example, iShares XCB — Corporate bond universe ETF has an average bond price of $114+; and after-MER gross yield of only 3.02% (worse than GICS!) and after-tax yield of 1.26% for a 57% effective tax rate.
My own view is that taxable investors would be better off owning individual bonds with a higher than market (7%) weighting in utilities, that they preferably buy at or near par with careful attention to after-tax returns.
In today’s environment, bond ETFs don’t belong outside tax sheltered accounts for most taxpayers
All very good points – but have a heart! I couldn’t resist doing a word-count on the above: 422 words, whereas I was allocated only 1000 for the entire article.
I’ll point out that the long-term Corporate ETF, ZLC is about 17% financial.
See also my article Bond ETFs Demystified.