Horizons Canadian Select Universe Bond exchange-traded fund (ETF), which recently opened for trading on the Toronto Stock Exchange, isn’t the cheapest in its category. Nor does its underlying index provide the broadest coverage of the Canadian investment-grade bond market.

What makes this exchange-traded fund (HBB/TSX) stand out is its tax efficiency. It’s the first fixed-income ETF in Canada to employ total-return swaps to obtain exposure to its market benchmark, rather than holding bonds directly as competing funds do.

All distributions of interest income will be immediately reinvested. These distributions will then be reflected in the mark-to-market value of the ETF’s total-return swap. Also, since the ETF does not hold any bonds directly, there won’t be any trading profits within the portfolio. Therefore, there will be no capital-gains distributions either.

Because of the absence of distributions, investors who hold this ETF in a non-registered account will avoid triggering a taxable event until they sell their units. When they eventually sell, presumably at a higher price, the difference between the selling price and the original price paid will be treated as a capital gain.

The management fee of Horizons Cdn Select Universe Bond is 0.15%, but that tells only part of the story when it comes to the cost of ownership. Horizons says the swap fees that make its tax efficiency possible will add another 0.15% a year in costs.

Even with the swap fee, which is charged by a counter-party, this is still an inexpensive fund. With its total cost of ownership of 0.30%, the fund’s fees are only modestly higher than those of the lowest-cost providers in the ETF industry, and by extension the investment-fund industry as a whole.

The Horizons ETF is about 10 basis points (bps) more expensive than BMO Aggregate Bond Index ZAG and Vanguard Canadian Aggregate Bond Index VAB, each of which charge a management fee of 20 bps. Though this would be a very significant price difference for institutional investors, Horizons’ higher cost is a modest price for individuals to pay to obtain meaningful tax savings.

Horizons’ combined fees also leave it at a price point that’s comparable to another key competitor, the $1.5-billion iShares Canadian Universe Bond Index XBB . This fund, the largest of any ETF that provides broad exposure to the domestic bond market, has a management fee of 0.30%.

The benchmark index for Horizons Cdn Select Universe Bond is the total-return version of the Solactive Canadian return index. The index was created by Solactive AG, which is based in Germany and is the index provider globally for index-linked funds with assets totalling roughly US$20 billion.

The Solactive index excludes the smallest 20% of corporate and the smallest 10% of government issues among the estimated total of 1,300 bonds in the Canadian investment-grade universe.

The index has about 180 constituent bonds, far fewer than the market benchmarks for the other TSX-listed index ETFs that provide broad domestic fixed-income exposure. BMO aggregate bond index and iShares Canadian universe bond index both track the FTSE TMX Canada universe bond index, which consists of about 1,000 securities.

However, because of the large number of bonds in the benchmark index, the BMO and iShare ETFs employ sampling techniques, rather than holding every single bond. With 794 holdings at last report, the iShares ETF holds a much larger sample of bonds than the $637-million BMO ETF, which as of March 31 had 487 holdings.

Also employing a sampling strategy is Vanguard Canadian aggregate bond index, which tracks a different benchmark but one that also provides broad investment-grade exposure.

As of March 31, the Vanguard ETF held 427 of the 708 bonds that constitute the Barclays Global aggregate Canadian float adjusted bond index. This index consists of investment-grade government and corporate bonds with maturities of greater than one year.

As Horizons officials point out, the sampling techniques employed by rival ETFs create the potential for tracking error. That is, the bond portfolio created to replicate the index may deviate from the index return. Also, the ETFs that hold bonds directly will incur trading costs on an ongoing basis as bonds are bought and sold to rebalance the portfolio.

By contrast, since Horizons Cdn Select Universe Bond does not hold individual bonds, there is no tracking error before fees and expenses, and there are no portfolio-rebalancing costs.

In choosing a broad-market bond ETF, what matters more to most investors than tracking error are the characteristics of the portfolio: average yield, credit quality, interest-rate sensitivity and the mix of issuers.

According to comparisons provided to Morningstar by Horizons ETFs, the Solactive Universe is broadly similar to the FTSE TMX Canada index employed by the BMO and iShares ETFs. As of March 31:

> Solactive had slightly higher credit quality, with 71.8% of its bonds rated either AAA or AA, compared with 64.7% for the iShares ETF that tracks the FTSE TMX index. Among BBB-rated bonds, the lowest investment grade, Solactive had a 7.5% weighting while iShares had 10%.

> Among government-guaranteed bonds, Solactive held 42.2% in federal issues, more than the iShares ETF’s 35.4%. Weightings in provincial issues were very close to each other, with Solactive at 28.7% and iShares at a slightly higher 29.5%.

> Both the Solactive index and the iShares ETF had an average weighted yield to maturity of 2.5%.

> Weighted average duration was 7.1 years for Solactive, which would make the Horizons ETF slightly more vulnerable to rising interest rates than the iShares ETF, which has a duration of 6.9 years.

One additional risk borne by the Horizons ETF is counter-party risk. Unlike funds that have direct holdings in bonds, the Horizons ETFs relies on a counter-party to carry out the total-return swap. The ETF’s returns are dependent on the creditworthiness of the counter-party and the smooth functioning of derivatives exchanges.

Horizons Cdn Select Universe Bond becomes the fifth ETF in the Horizons family to employ total-return swaps, joining Horizons S&P/TSX 60 Index HXT and Horizons S&P 500 Index HXS and two industry-sector ETFs. Though these four funds are also subject to counter-party risk, the swap obligations have consistently been met.

Rudy Luukko is editor, investment and personal finance, at Morningstar Canada.