Tax Loss Harvesting Strategies with Discount Bonds

Bonds – a necessary asset allocation tool

2022 has been a difficult year for investors owning bonds and bond funds. Rising rates have caused significant price declines in high-quality government bonds while the fear of recession is causing tremendous volatility in lower-rated corporate and high yield bonds.

Managing a portfolio is a disciplined asset allocation process. In a landmark 1986 study, Brinson, Beebower and Hood found that ​“asset allocation is the primary determinant of a portfolio’s return variability.”¹ Bonds are a critical asset class in the overall allocation process and continue to act as a buffer to stubbornly high market volatility. The standard deviation of ZBAL, the BMO Balanced ETF—a 60% Equity and 40% Fixed Income solution — is 10.14% as of September 1, 2022, compared to ZCN, the BMO S&P/TSX Capped Composite Index ETF, at 17.09% and ZUE, the BMO S&P 500 Hedged to CAD Index ETF, at 19.22%. Clearly, bonds retain their value as a diversifier and volatility buffer in the asset allocation process.

Bonds are a critical asset class in the overall allocation process and continue to act as a buffer to stubbornly high market volatility.

The taxation of bonds

Tax is often a primary concern of high-net-worth investors and their portfolio managers and investment counselors. Bonds pay interest based on their coupon, which is typically stated at issue as a percentage of the bond’s face value. This interest is taxed as income, is reported to investors on their T5 slip, and should be reported on their annual tax return. Interest income is taxed at the highest tax rate, which is why investment professionals recommend holding fixed income investments in tax-sheltered registered accounts as often as is possible. But this simple adage makes it difficult to manage risk in taxable accounts. Fortunately, there is a solution.

The solution: discount bonds

Discount bonds are an often-overlooked solution to this problem. A discount bond is a bond that is issued at a lower price than its par value, or a bond that is trading in the secondary market at a price below par value. A bond is considered to trade at a discount when its coupon rate is lower than prevailing interest rates. From a tax perspective, the difference between the par value of a bond at maturity and the adjusted cost base — the original purchase price of the bond — is considered capital gains or losses. So, when comparing bonds of similar credit, duration, and yield to maturity (YTM), it follows that a discount bond with a lower coupon will be a more tax efficient solution.

How do discount bonds work?

When an investor purchases a bond, they expect to be paid interest by the bond issuer — the fixed coupon. The value of the bond will increase or decrease with changes in market interest rates. If interest rates rise after a bond is issued, the investor will end up holding a bond that is paying interest at less than current market rates. New investors need to be offered a discount to be attracted to buy the bond. Said another way — with changing interest rates, bond prices must adjust so that their YTM, or total return, equals or is almost equal to the YTM of new bond issues with similar credit and duration.

ZAG vs. ZDB – an illustrative example

Source: BMO Global Asset Management, as of September 30, 2022.
Weighted Average Yield to Maturity: The market value weighted average yield to maturity includes the coupon payments and any capital gain or loss that the investor will realize by holding the bonds to maturity.

In this example, we compare ZAG, the BMO Aggregate Bond Index ETF, and ZDB, the BMO Discount Bond Index ETF. At $5.8 billion in assets under management (AUM), ZAG is Canada’s largest bond ETF² and a go-to solution for investors of all stripes. While ZAG is a great solution for non-taxable registered accounts, there’s a compelling argument to be made to use ZDB in taxable non-registered accounts.

In ZAG and ZDB, the weighted average yield to maturity, duration and credit are the same, meaning the client has the same exposures. But there is one important difference: the weighted average coupon of ZAG is 2.82% vs the ZDB coupon of 2.00%. Assuming a $100 investment and a tax rate of 40%, this means that the owner of ZDB is subject to a tax bill that is 30% lower than the owner of ZAG.

In addition, ZAG will have a compressed Net Asset Value (NAV) because Premium bonds decline in price to mature at par. In contrast, ZDB will have a rising NAV because Discount bonds rise to mature at par.

The interest rate trajectory, after over 20 years of downward movement, has turned up quickly as a result of aggressive rate hikes to combat inflation levels that are approaching or exceeding 40-year highs.

A strategy for the current environment: tax loss harvesting into discount bonds

Conditions are emerging in the financial markets that we haven’t seen for several decades. The interest rate trajectory, after over 20 years of downward movement, has turned up quickly as a result of aggressive rate hikes to combat inflation levels that are approaching or exceeding 40-year highs. As one would expect, secondary market bonds with fixed coupons reacted accordingly, by dropping in value and trading at a discount. While not ideal, this presents an opportunity for portfolio managers and investment counsellors to effectively manage clients’ tax liability. If those bonds are held in taxable accounts at a discount, they can be sold to generate a capital loss to use against future capital gains. The proceeds of that sale can be moved into a discount version of that position so as to keep the exposure while minimizing tax liability.

BMO’s suite of discount bond ETFs

BMO is the largest provider of bond ETFs in Canada.³ We have a full suite of ETFs that portfolio managers, investment counselors, family offices and foundations can use as asset allocation tools to manage their bond exposure by credit, term, duration and now, thanks to our suite of discount bond ETFs, tax exposure.

For clients who want core broad bond exposure that approximates the Canadian universe with a lower coupon:

• ZDB: BMO Discount Bond Index ETF – Fee: 0.09%; 100% investment grade

For clients wanting high-quality government bonds, less sensitivity to rising rates, and a lower coupon:

• ZSDB: BMO Short-Term Discount Bond Index ETF – Fee: 0.09%; 100% investment grade

And for clients wanting a corporate yield pickup with high-quality bonds, less sensitivity to rising rates and a lower coupon:

• ZCDB: BMO Corporate Discount Bond ETF – Fee: 0.15%; 100% investment grade
  
  

To learn more about bond ETFs as a means of optimizing your portfolios, reach out to your BMO Institutional ETF Specialist.

¹ Gary P. Brinson, L. Randolph Hood, and Gilbert L. Beebower, ​“Determinants of Portfolio Performance,”1986.
² Assets under management, CETFA, as of September 30, 2022.
³ Ibid.