Dan Bortolotti: Bonds are one of the least tax-friendly asset classes: most of their return comes from interest payments, which are taxed at the highest rate. They’re even less tax-efficient when their market price is higher than their par value: these premium bonds are taxed so unfavorably they can actually deliver a negative after-tax return. Unfortunately, because interest rates have trended down for three decades, virtually every bond index fund and ETF is filled with premium bonds. Enter the BMO Discount Bond ETF (ZDB), which begins trading tomorrow. This unique new ETF promises to eliminate the problem that has long plagued bond funds in non-registered accounts.
Let’s take a step back and review the important idea underpinning this new ETF. Consider a premium bond with a coupon of 5% and a yield to maturity of 3%. The bond will pay you 5% interest annually and then suffer a capital loss of 2% at maturity, for a total pre-tax return of 3%. Now consider a discount bond that pays a coupon of 2% and has the same yield to maturity of 3%: now, in addition to the interest payments, you’d net a 1% capital gain at maturity, and your total pre-tax return would again be 3%. In an RRSP or TFSA, therefore, these two bonds would be virtually identical.
But not so in a taxable account: the investor holding the premium bond would be fully taxed on the 5% interest payments and would suffer a capital loss—a double whammy. Meanwhile the holder of the discount bond would be fully taxed on just 2% in interest, and then taxed on only half the 1% capital