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.
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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