Super Tax Efficient Bonds

When held outside of a registered investment account (TFSA and RRSP), interest revenue is the most heavily taxed form of investment income. In fact, interest income is taxed added to your employment and other income and taxed at your full income tax rates in the province where you live.

We know income tax rates are pretty steep in Canada at the higher ends of the income curve. For a $100,000 income, interest income will be taxed at rates ranging from 36% in Alberta to 45.7% in Quebec. That is correct, nearly half of your interest income will be funneled right back to the government. Perhaps not ironic considering governments are also the largest debt issuers, so Canadians who own bonds are likely to own are large number of government bonds.

It's no wonder that bonds have not been a very attractive investment in the recent past. Not only are interest rates very low (a sub-3% yield on most major bond ETFs), the net returns after the huge tax hit shrink the returns down well below 2%. That is nicely below the current 2.3% inflation rate.

Although a 1.7% or 1.8% net yield might give you the illusion that you are coming ahead a little bit when holding bonds, with inflation factored in you are actually achieving a negative investment return. All while taking on the risk of investing your money. It's certainly unlikely that our governments will default on their bonds any time soon, but if you hold corporate bonds that is a very real possibility.

Avoid Interest Income with HBB.TO

Given the high penalty of earning interest income in the current financial and taxation environment, any investor who invests in bonds through their non-registered investment account should avoid holding bonds or ETFs which generate interest income.

Thanks to a unique swap structure (contractual arrangement between two parties), Canadians have access to an increasingly popular ETF which invests in bonds but provides no interest income. Instead of distributing interest income as is common in a standard bond ETF, a swap-based ETF will simply apply that interest income to the Net Asset Value of each ETF unit behind the scenes.

The bond ETF I'm talking about trades on the Toronto Stock Exchange as HBB.TO. It is swap structure ETF which tracks the total return of the Solactive Canadian Select Universe Bond Index. It generates similar results as the more popular XBB.TO (sold by iShares Canada) and VAB.TO (sold by Vanguard Canada) which also track nearly identical Canadian Universe Bond indices.

The management fees on this Horizons Bond ETF (HBB.TO) have recently been reduced again to 0.09%. There is an additional embedded swap contract fee up to 0.15% per year (it was 0.1448% in 2017). However, for that fee you have zero distributions, the fund incurs no taxes, there are no other behind the scenes transaction costs, and the ETF tracks the total return of the bond index perfectly.

In a way, you could think of the swap fee as a sort of tax as it represents an additional drag on the returns of the ETF that the more conventional ETFs (XBB.TO and VAB.TO) do not have. But that fee should not scare you as it is a very cheap fee.

Swap Costs vs. Tax on Interest

To keep the math when comparing the two categories of ETFs simple, we'll assume that the underlying indices of the various bond ETFs will perform the same over long periods of time.

Although the Solactive Index is new, the holdings are very similar to the more popular FTSE TMX Bond Index (used by XBB.TO and ZAG.TO) and the Bloomberg Barclays Bond Index (used by VAB.TO). Each index allocates around 70% to governments, 10-12% to financials, and 9-10% towards energy and utilities. The remaining 10% is allocated to telecoms, consumer stores, real estate, and industrials.

Since there are no distributions of any sort with HBB.TO, there are no taxes along the way. Instead, there is a simple deferred capital gain and the swap fee which is not charged by the conventional bond ETFs. Let's see how that swap fee compares to the tax costs on interest income from the conventional bond ETFs.

Source: TheRichMoose.com

Regardless of the income level, the additional fees on HBB.TO are multiples cheaper than the income taxes on other bond ETFs. The higher your personal income is, the higher the savings will be.

Over time, the savings on taxes will have a big impact on your total portfolio. If you invest $100,000 and achieve a 3% return, your portfolio will grow to $245,000 over 30 years. The same amount having an after-tax return of 2.1% will grow to just $187,000. A difference of $58,000, or 24% of your total return.

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Exaggerated Tracking Error Fears for Leveraged Funds

Daily leveraged funds are still quite new to the retail investor. The first 2x leveraged ETFs tracking broad market indices started trading in the middle of the last decade.

Just a few years later, anyone investing in these ETFs who was not sure about their performance in all market conditions was rudely woken. The largest 2x fund tracking the S&P 500 suffered from an 85% drawdown in the 2008-09 Financial Crisis. That's correct, every $1,000 in this ETF shrank to a mere $150.

Since that time, the you've heard the warnings over and over. From the financial news, your run-of-the-mill financial advisor, most financial blogs and online sources, and even the large and prominent disclaimers on fund provider websites.

Like this one directly from Horizons Canada's website:

"The ETF uses leverage and is riskier than funds that do not. The ETF seeks a return, before fees and expenses, of +200% or - 200% of its Referenced Index for a SINGLE DAY. The returns of the ETF over periods longer than ONE DAY will likely differ in amount, and possibly direction (of the performance, or inverse performance, as applicable) of the Referenced Index. Longer periods AND/OR greater volatility will make the possible divergence more pronounced. Investors should monitor their investment in this ETF daily. Please read the prospectus and ensure you understand this ETF before investing in it."

The prevailing wisdom is simplified to this: leveraged ETFs are very, very risky. They are only for use by a professional day trader who watches their brokerage account throughout every trading day. Do not hold leveraged ETFs unless you want to lose your money.

What Does the Data Say

For a few years now I've been quite skeptical of these claims. It is only logical that daily leveraged funds of reasonably stable indices should outperform their underlying index over longer periods of time, even after adjusting for fees.

I believe the argument made by the crowds is an oversimplified one. Certainly a leveraged daily fund will not provide an exact specified multiple return over the underlying index for any period greater than one day. Volatility guarantees that. Large down days do damage, while positive returns over numerous days compounding each day provide outsized returns.

However, it's time to debunk the myth of danger surrounding these funds. Over the past weeks I've compiled a large spreadsheet of daily returns for the S&P 500 since the beginning of 1950. Then I simulated the annual performance of daily leveraged funds from 1950 to 2017.

In the 68 calendar years of data I compiled, a 3x daily leveraged fund would have returned a 2.5x or higher multiple of the S&P 500 in 53 of those years. Further, an another 11 years would have still been a positive multiple of the index, although less than 2.5x.

This means in 95% of all years in more than one-half of a century, a 3x daily leveraged fund would have returned a positive multiple of the S&P 500.

In just four years the annual return was negatively correlated to the underlying index: 1960, 1987, 2011, and 2015. The pattern in each of these four cases is quite similar. In 1987, 2011, and 2015 the stock market had a correction which occurred near the end of the calendar year. In 1960, the market was just very up and down from start to finish. In 1960, 2011, and 2015 the S&P 500 was just barely positive on the calendar year, so the negative multiple return of the leveraged fund would not have had a substantial impact on the investor.

The only year where the 3x leveraged fund would have a large negative impact was 1987. As most investors with some knowledge of market history know, 1987 was a memorable year. In a single day, October 19, the U.S. stock market experienced its largest daily fall ever with a -20.47% return. On a 3x daily leveraged fund, that translates to a single day return of -61.41%. As you would expect, a large daily loss of this magnitude takes time to recover.

However, if it's any consolation, in four years since 1950 a 3x leveraged fund would have returned more than 4x the underlying S&P 500 index thanks to the power of daily compounding of positive returns: 1953, 1954, 1958, and 1990.

Summary

The data shows that a daily leveraged fund performs according to its expected return over the course of an entire calendar year more than 80% of the time. This is a high rate of success and shows that in the vast majority of market conditions daily leveraged funds on broad market indices are not significantly impacted by the historic market volatility.

In the past 67 years, there was only a single year where holding daily leveraged funds of the S&P 500 would have negatively impacted a investor to a substantial degree because of volatility induced tracking error. I believe it's safe to say 1987 was a unique year in stock market history that is not likely to be frequently repeated in the future.

While all investing with leverage carries risks that are amplified when not used properly, the common wisdom that leveraged ETFs should be used for short-term or day trading only is misplaced. Under the vast majority of market conditions throughout history, the divergence of daily leverage when held for longer periods of time is not substantial.

Always remember when the underlying index enters an extended drawdown, the effects of that drawdown will be amplified with daily leveraged ETFs. This is common and should be expected. Despite their simulated tracking history over long time periods being better than commonly held beliefs suggest, it would be reckless to allocate the majority of your portfolio or tax-advantaged account within your broader portfolio to a leveraged ETF.

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All comments are moderated before being posted for public viewing. Please don't send in multiple comments if yours doesn't appear right away. It can take up to 24 hours before comments are posted.

Comments containing links or "trolling" will not be posted. Comments with profane language or those which reveal personal information will be edited by moderator.