Multi-Sector bonds

In normal times, bonds are mostly sources of interest income, so they aren’t top of mind when thinking about tax efficiency. But this year could well be different in the wake of 2022’s market losses. The reason: an abundance of bonds trading at prices well below their maturity values.

All portfolio managers of retail fixed-income funds can take advantage of these bond discounts to generate capital gains for the benefit of investors with non-registered accounts. Focused specifically on this goal are a handful of discount bond ETFs.

The oldest and largest is the $794-million BMO Discount Bond Index ETF, launched in February 2014. The ETF provides “universe-like exposure” while selecting bonds that are likely to be more tax-efficient, said Matt Montemurro, portfolio manager, ETFs, with Toronto-based BMO Asset Management Inc.

Generally that means low-coupon bonds for the BMO portfolio, which tracks the performance of the FTSE Canada Universe Discount Bond Index. Also in the BMO lineup are two other discount strategies — the $47-million BMO Short-Term Discount Bond ETF and the $34-million BMO Corporate Discount Bond ETF — that both launched in January 2022.

BMO’s largest challenger is the $757-million RBC Canadian Discount Bond ETF, which debuted in June 2019 and is an actively managed portfolio of short-term bonds.

In choosing from bonds that have the same credit quality and duration, and may even be from the same issuer, the RBC ETF’s portfolio managers select the lower-coupon bond.

“The market will adjust for price and so the yield to maturity should be the same,” said Stephen Hoffman, vice-president, ETFs, with Toronto-based RBC Global Asset Management Inc. The makeup of the total return will differ, Hoffman explained, with lower interest income and therefore higher capital gains, “assuming an environment like we have today where bonds are trading at a discount.”

The newest contender is the Dynamic Active Discount Bond ETF, which has grown to $234 million since its launch in November. The Montreal-based management team led by Marc-André Gaudreau has the most active mandate, and its portfolio is the most differentiated from the broad Canadian bond market.

The Dynamic ETF invests primarily in investment-grade Canadian corporate bonds with maturities ranging between three and seven years. The weighted-average price of the bonds it holds must be below the average price of the bonds in its benchmark, which is a hybrid of two corporate-bond indexes.

The combination of wider spreads between corporates and Canada issues, relatively high yields for quality issues and attractive discounts on bond prices make for a compelling investment opportunity, Gaudreau said.

As for management fees and expenses, the low-cost providers are the BMO Discount Bond Index ETF and its short-term counterpart, both at 0.10%, while RBC charges 0.17%. The Dynamic ETF, with its greater reliance on credit research, has a management fee of 0.35%, not including expenses.

Since the investment strategies and holdings of the various discount bond ETFs are markedly different from one another, so too are their potential picks. The BMO Discount Bond Index ETF’s holdings must be fixed-rate Canadian bonds with coupon rates that are less than or equal to 1.4 times their yield to maturity.

In the current market, this represents a low bar. In fact, Montemurro said, of the 1,653 bonds in the Canadian investment-grade universe as of late February, all but 92 would be eligible for the ETF. That means the roughly 400 holdings will be more deeply discounted than in the past. “The overall fixed-income universe is more tax-efficient than it was two years ago,” Montemurro said.

This trend also holds true for the short-term Canadian bond universe in which the RBC ETF invests. As of the end of January, the latest figures provided by Hoffman, the weighted average discount per $100 face value was $7.07, which was almost twice the discount of the market as a whole.

The weighted average coupon for the RBC ETF was about 1.2%, versus 2.5% for the index. “When we focus on bonds that have lower prices, that will result in a portfolio that has a lower coupon,” Hoffman said. Since yields to maturity will be similar for higher- and lower-priced bonds that otherwise have similar credit quality and duration characteristics, the lower-coupon bonds should have a higher capital-gains component to their total returns.

However, the RBC ETF’s yield to maturity as of Jan. 31 was 4.35%, or 28 basis points higher than the index. This was due to RBC GAM’s decision to significantly overweight corporate issues at 60% of the portfolio, nearly double the index weighting of 33%.

Corporates are overweighted because they tend to earn higher returns, Hoffman said. Research by Dagmara Fijalkowski, head of fixed income with RBC GAM, found that at the short end of the maturity spectrum, corporate bonds outperformed Canada bonds about 80% of the time in terms of total return over a 12-month period.

Along with the yield advantage that corporate issues enjoy over Government of Canada bonds, the three-to-seven year maturities that the Dynamic Funds team focuses on has the highest “positive convexity,” Gaudreau said. By that, he means greater price sensitivity to declines in market yields, and therefore greater potential for capital gains since bond prices and market rates generally move in opposite directions.

The Dynamic ETF’s mandate allows it to hold as much as 40% in government bonds under adverse market conditions. Currently its government allocation is 10%, providing a measure of defensiveness and a source of liquidity to take advantage of future opportunities.

Unlike the purely Canadian discount strategies at BMO and RBC, the Dynamic fund can have a modest allocation to U.S. bonds, as it has in the recent past. When these bonds are held, the U.S. currency exposure is fully hedged back to the Canadian dollar.

Currently, the Dynamic fund is taking a defensive stance, underweighting BBB issues and overweighting higher-quality bonds, such as senior issues from major Canadian banks. Even if there’s a recession this year, there are “reasonable opportunities” in high-quality issues, Gaudreau said.

”Eventually there’s going to be great opportunities down the risk curve,” he said. “But from a timing standpoint, I’m not sure we need to be aggressive now. There’s probably going to be a better time in the future.”