Friday, 28 March 2014

Canadian Transportation Companies - Sustainability, Social, Environmental and Governance Ratings

Just as we have previously done for Consumer companies, Mining, and Oil and Gas stocks, today we will take a look at how well Canadian firms in air, rail, truck and marine transportation rate on key corporate sustainability factors. We'll also have a look at their financial and stock performance.

Same Methodology - 3 Key Factors
In the same manner as before, we dig up data through reports like the annual Proxy Circular filed on Sedar, or through a Sustainability report filed on the company website or on the Global Reporting Initiative database, on three key aspects that researchers have found (see especially the Mining post for the details and further links) are especially useful in finding companies that will outperform for the investor.

1) Board of Directors committee with a sustainability mandate
2) Executive compensation tied to ESG performance
3) Formal stakeholder engagement processes

We also gathered other evidence that a company has been taking sustainability seriously:
4) Published, annual, up to date corporate sustainability reports, preferably audited and submitted to GRI
5) Membership in voluntary sustainability-related reporting and promotion organizations like Carbon Disclosure Project, Canada's Top 100 Employers, Green Marine, Canada's Best Managed Companies, Sustainalystics / Macleans Top 50 Socially Responsible Corporations 2013, Tour Operators’ Initiative for Sustainable Tourism Development, Randstad Award for Canada’s Most Attractive Employer 2013
6) Constituent of the iShares Jantzi Social Index ETF (TSX: XEN) that holds only companies with better social and environmental ratings
7) High rating in the Board Shareholder Confidence Index published by the Clarkson Centre for Business Ethics and Board Effectiveness
8) Women on the Board of Directors

The results are a mixed bag. The pattern is, the bigger the company, the more explicit and extensive the adherence to sustainability.

No evident sustainability efforts - Cargojet, HNZ Group, Contrans Group, TransForce

Some sustainability initiatives - Air Canada, Chorus Aviation, Transat, Trimac, Algoma Central and Logistec

Integral to operations and strategy - Westjet, CN Rail and CP Rail. For example, CN's latest Sustainability Report, with its reams of pertinent statistics on environment, safety, people, and its priorization of issues in the chart reproduced below, provide convincing evidence that the company is doing more than paying lip service to sustainability.

Financial and stock performance not apparently related to Sustainability
The next table sorts the companies by their annualized total stock return (capital gains plus reinvested dividends) over the last five years.

There seems to be no relationship between sustainability rating and stock performance. (We note in passing that every stock but Transat has handily outstripped the return of the overall TSX, as measured in a benchmark fund such as iShares S&P  / TSX Capped Composite ETF (XIC), which achieved a compound return of 12.5%).

There are also seems to be no relationship between sustainability and company profitability, as measured by Return on Equity or Assets.

Bottom Line: As we noted before in the face of similar results for Oil & Gas and Consumer stocks, it may be that the research-established relationship between sustainability action and corporate success takes longer to manifest itself. In the meantime, the role of this sustainability assessment may thus be more to assist those investors who wish to select their investments on philosophical grounds in addition to the financial numbers.

Disclosure: This blogger owns shares of CNR.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Friday, 21 March 2014

Picking Countries with a Weak Currency - How did it perform?

About a year ago in Using Weak Currencies to Find Foreign Equity Investment Opportunity, we wrote about research findings that found that equities in countries which had experienced prolonged weakness in their currency subsequently performed much better than the average. We dug up the data and identified seven individual countries and the Euro area, all of whose currencies had taken a battering. Let's now see what happened. Did those countries' equity equity markets do well for a Canadian investor?

The Eight Weak Currency Countries of Last Year - Win big or lose big
Last year's post listed available ETFs for each country and the Euro area, so we simply went to the ETF provider's website to get the return performance. Then we adjusted the return for the fact that since many of the ETFs trade in US dollars on US exchanges, the fall in value of the Canadian dollar (CAD) against the US dollar (USD) boosted results for a Canadian investor (i.e. each USD bought more and more CAD over the year). In fact, the USD went from buying $1.0285 CAD to $1.1065 between 1st March 2013 and 28th February 2014, a 7.58% rise, which is what we added to the returns for each of the US quoted ETFs.

1) Euro area:

That's an outstanding return, far ahead of a benchmark such as one for all non-North American developed countries, which happens to have a heavy loading of Euro holdings, the EAFE (Europe, Australia, Asia and the Far East) ETF from iShares Canada, iShares MSCI EAFE IMI Index ETF (TSX symbol: XEM). XEM's return was also outstanding but considerably less at +29.3%.

2) Denmark:
That's amazing return (imagine the TSX rising that much in a year!) and far better than the EAFE benchmark.

3) India:
These slightly different funds gave slightly different results. However, it is worth noting that the total return of the Canadian quoted funds, taken directly from the provider website, ended up in the same ballpark, after the CAD vs USD return is taken into account, as for the US-quoted INDY, whose USD return was -2.47% before the currency return was added. This demonstrates what we have noted before - that the currency change that matters is not the USD in which the ETF is traded but the shift between CAD the relevant country currency.

Note also that this positive return handily exceeds the return from the average of Emerging market countries in a benchmark fund such as the iShares MSCI Emerging Markets ETF (NYSE: EEM), whose total return was +1.0%.

4) Brazil:
This is far worse than the EEM benchmark.

5) Indonesia:
This is also far worse than the EEM benchmark.

6) Poland:
Another EEM benchmark beater.

7) South Africa:
And another EEM benchmark beater.

8) Turkey:
This is another massive under-performer of the EEM benchmark.

That's five winners and three losers in the weak currency sweepstakes.

There was a correspondence between each country's currency performance and the equity returns. Clicking through each country's one-year currency Visualizations Market Map chart on RatesFX, those with depreciating currencies with lots of bright red, like Indonesia, Turkey and Brazil, had poor equity returns, while those with good equity returns, like the Euro (chart image below), Poland and Denmark, saw their currencies appreciate - lots of blue on the chart.
(click to enlarge)
India and South Africa's currencies had strong bright red depreciation with modest though benchmark-exceeding returns. Last year they evidently hadn't yet hit the bottom of the currency path. Maybe the strong returns are to come.

The latest weak currency countries
Going through the same scan of the latest three-year currency performance on RatesFX, the countries with the telltale red of depreciation are:

1) Japan - Performance of Japanese equities was excellent in the 12 months ending February 28th, aided by the weak currency for a Canadian investor - up 21.3% in the iShares MSCI Japan ETF (NYSE: EWJ). Perhaps after many years of stagnation, market returns will remain positive. The Credit Suisse study we cited last year found that superior equity returns subsequent to currency weakness could persist for years. The valuation metrics on EWJ's webpage are moderately attractive - a fairly high Price/Earnings of 19.3 and a low Price/Book of 1.7.

Other ETFs to invest in Japanese equities, all traded on US stock markets, are listed in the ETFdb. There is only one unleveraged Japan-only equity traded in Canada, the iShares Japan Fundamental Index Fund (CJP), which is CAD-hedged, a feature that isolates market moves from currency moves in the short term, though it does impose a significant drag on returns in the long term, as we discussed in this post.

2) Chile - The equity market, as tracked by the iShares MSCI Chile Capped ETF (NYSE: ECH), did very poorly in the last twelve months, returning a huge decline of 25.2% for a Canadian investor. EWJ's valuation metrics are only somewhat appealing with a high P/E of 22.8 and a low P/B of 2.0.

3) Canada! - Except for other countries, several noted above, whose currencies are even weaker, the CAD has a weak track 3-year record against all major currencies (chart below). Choices of ETFs to invest in Canadian equity are many - see our reviews of Canadian large cap equity ETFs and a comparison of Canadian low-volatility with cap-weight ETFs.
(click to enlarge)

Valuation metrics of the Canadian equity benchmark iShares S&P/TSX Capped Composite Index Fund (TSX: XIC) are quite reasonable - a P/E of 16.6 and P/B of 2.0. Perhaps good returns are in the offing for investors in Canada's equity market.

Bottom line: Like all long term statistical relationships determined across many countries and multiple years, the one where weak currency presages stronger equity equity returns doesn't work without fail in every instance and it hasn't worked in the past year for every currency/country, only a majority of five out of eight. It also seems to be a "win big or lose big" proposition.

As for implementing a strategy to exploit the weak currency phenomenon, our post last year noted what we think are steps in a prudent approach. In addition,To adopt such a strategy is probably not for everyone. The best option for most investors who don't wish to take the time and trouble to track, then buy and sell the individual country holdings, is to invest in a few broad index funds like the benchmarks above (or the best in each category - see our comparisons of Emerging Market equity ETFs and diversified Developed Country ETFs).

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Thursday, 20 March 2014

Canadian ETFs with High After-Tax Cash Yields - Separating the Good from the Not so Good

Where does an investor find ETFs with a high after-tax cash payout? And what is the potential negative side of high payout funds, is there an Achilles heel? In general terms, the main potential negative is that a high payout may not be based on true investment return but merely be paying back the investor's own capital. Linked to this is the question of the likely future sustainability of the payout. What does the continued high payout depend on?

However, the first job is to find the funds. One place to start looking for such ETFs is a website like Best Dividend ETFs which posts a list of Dividend ETFs with Domicile in Canada that currently distribute a lot of cash. We've taken that list and added other funds that looked promising. Other promising funds can be unearthed by looking through the tax breakdown for the previous year that the ETF providers publish every year around this time for their own ETFs. The trick is to look for ETFs that have handed out tax efficient income, starting with return of capital (ROC), then dividends and capital gains. Interest income and foreign income are taxed at the highest marginal rate so those types of funds are less likely to distribute a lot after-tax.

To assess the best after-tax net return, we gathered data for ETF performance over the year 2013, incorporating three factors: i) the pre-tax payouts, ii) the tax breakdown of distributions as published by the ETF providers and iii) the tax rates that apply to return of capital, dividends, capital gains and foreign or interest income.

Today's post updates the review we did last year in two posts -   first, on the net returns in 2012 and second, on the likely sustainability of their high payouts. Redaders will note that many of the same high payout funds are on this year's list but that doesn't necessarily mean they are good choices.

The High After-Tax Payout ETFs
In the comparison table below, the results show how much cash return was received by an investor in the second highest Ontario tax bracket - $135,000 to $509,000 - or in a middle income bracket - $70,000 to $79,000 - in percent yield and in amount retained per dollar of cash received. There are some differences in ranking of the funds since higher rate taxpayers pay less tax on capital gains than on dividends while the reverse is the case for the middle income person, but the order is roughly the same.
(click on image to enlarge)

Many of the top payout funds in 2013 relied on bad Return of Capital (ROC) - The table highlights in red text the bad-ROC ETFs where the high tax efficiency and payout consists of large dollops of ROC and where the fund endured a net decline in Net Asset Value (NAV). As we have written in the past in the above linked posts and in the ever-popular Return of Capital: Separating the Good from the Bad, an ETF that merely pays an investor back his or her capital is not providing worthwhile performance.

Several other top payout funds have lost their advantaged edge - The grey shaded cells show the funds that last year lost their tax advantage when the federal government budget invalidated the transformation of interest income into capital gains by use of a forward agreement. Some funds ended the forward agreements later in 2013, like CVD, and others like CSD, CHB and HAF have adopted a transition strategy that uses the grandfathered existing forward agreement till expiry. Despite being allowed to continue for that limited time, their tax benefit will nevertheless be progressively diluted as new subscriptions enter the fund gaining normal interest that will be distributed as such to all shareholders old and new alike.

Call option revenue underlies a handful of high payout funds - Five funds - LXFHEX, ZWU, ZWB and HEF - rely on revenue from writing covered calls on their portfolio holdings to generate tax efficient extra income for distribution to shareholders.

Call option revenue is treated as capital gains but several of the ETFs in the table have no capital gains but lots of ROC. BMO's ETF Taxation background document explains how this happens: "From a tax perspective, the gains from writing options are combined with gains and losses from trading the underlying portfolio. If the underlying portfolio trades have generated losses, these losses reduce or negate the tax gain from the written options and create ROC." When that occurs, the fund may only be distributing cash equal to the sum of call writing income and dividends, but the NAV capital loss portion from trading losses is bad ROC.

Rising markets are key for a couple of high payout funds - Two funds - FIE and XTR - pay out a pre-set steady stream of cash that is partly based on unrealized capital gains, and thus becomes return of capital, from increases in the market value of holdings. In years when markets decline the ROC will be bad and in up years like 2012 and 2013, the ROC will be good. Long term success depends on markets rising more than they fall over the years.

Dividend stock focus explains the last group of high payers - Our table of the top 15 best after-tax payouts contains three funds whose high cash distribution depends on a portfolio of stocks paying healthy dividends - ZDV, ZUT and XEI. The funds merely pay out what they generate.

Major Canadian Index ETFs are tax efficient for middle income investors but not nearly as much for high bracket earners - For comparison we compiled the same data for some of the most popular Canadian equity index ETFs. The first thing we note is that generally the net after-tax payouts are much more modest, in the 2- 3% range across both income tax brackets. But the tax efficiency in terms of amount of each pre-tax dollar retained after tax is much better for the middle income earner, around 86 cents on the dollar, than for a a high bracket investor. The index funds mainly pay out dividends, which are taxed less in the middle income investor's hands.
(click to enlarge)

There is not much difference in efficiency between the highest cash payout funds and the index funds for the middle income investor. There is a great deal more difference for the high income investor - 72 cents on the dollar retained from the index fund payout vs as much as 90+ cents. The high payout funds with high efficiency are a much more appealing proposition for high earners.

Sustainability of cash payouts is a challenge for most high payout funds - Our next comparison table calculates the gap between the payout rate and the amount of income the holdings generate in dividends or interest net of MER. We have highlighted in salmon colour those ETFs where there is a substantial shortfall that must be made up somehow to avoid paying out bad ROC.
(click to enlarge)

Covered call writing ETFs need to generate the extra revenue primarily from the call writing. As we have discovered through seeing long term declines in NAV at most of these funds, it isn't easy. LXF, HEX, HEF and ZWU have all failed so far and suffered falling multi-year NAV. Only ZWB has managed to hold its NAV at least level.

But that ignores another key issue - ZWB is falling well short in total return performance. Compared to another ETF composed entirely of financial stocks, the iShares  S&P/TSX Capped Financials Index Fund (TSX: XFN) it has exhibited the flaw discussed by Rob Carrick in the Globe when the flurry of covered call ETFs were launched in 2011, namely that they are more or less fully exposed on the downside but only capture a portion of the upside. XFN's one year total return to the end of February is 18.5% vs only 12.7% for ZWB.

Two other funds - FIE and XTR - rely on a rising market to generate capital gains that are distributed unrealized to shareholders as ROC. This works in the long term and cash payouts are sustainable, as long as markets rise more than they fall. Some years the constant payouts the ETFs have set will exceed gains, or the market will go down, and the funds distribute what is hopefully temporarily bad ROC, to be caught up when the market goes back up. XTR was launched in 2005 and survived through the
financial crisis so maybe it is a viable strategy. Its five year total return of 17.0% to the end of February even handily beat the 13.7% of a common benchmark fund, the iShares S&P/TSX 60 Index Fund (XIU) . There is a tax advantage to receiving immediately non-taxed ROC (which is taxed later as capital gains when the investor sells the shares) so such a fund can make sense for taxable investors who want cash now.

Finally there are the funds holding dividend stocks like ZDV and XEI, which only distribute what they actually receive from the holdings, i.e. mostly dividend income. We had to cut the table off for lack of space but other dividend ETFs (reviewed recently here) like XDV, PDC, PDF are not far behind. Other funds with higher payouts that similarly only distribute what they receive like REITs and preferred share holding funds are also not far behind.

Bottom line - High payouts often come with the downside that more cash now means lower long term returns. Funds that distribute only what the under-lying portfolio generates naturally have a much better prospect of long term sustainability. As the old expression goes, it's not possible to make a silk purse out of a sow's ear.

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Tuesday, 11 March 2014

How to Avoid the Misery of T1135 Foreign Holdings Disclosure

When we last wrote about the T1135 Foreign Income Verification Statement, the form required by the Canada Revenue Agency when certain specified foreign assets of a Canadian taxpayer exceed $100,000 in cost, things were complicated enough. Well, things have got worse. The CRA is now requiring a lot more detail on the foreign assets and the rules as to when exactly the detail is needed or not have become even trickier.

A selection of articles on the T1135 trauma

Investors may well cry out - help! how do I escape this? Below we offer some suggestions for equity ETFs that escape the CRA net yet still provide foreign holdings for a portfolio. But first we need to narrow the task.

Amidst all the complexity, a few things are clear: 
1) Most notably for the majority of taxpayer investors, is that holdings within registered plans like RRSPs and other forms of registered retirement plans - LIFs, RRIFs, LIRAs etc, TFSAs, and RESPs are exempt from the necessity to report on the T1135, no matter what their value. 

2) Apart from these exempt accounts, what matters is not the currency of the holding, nor whether the broker is Canadian or outside the country, nor the stock exchange where the investment is bought or sold. Canadian company bonds denominated in US dollars are still Canadian. Royal Bank stock traded on the NYSE is still Canadian. US company stock held in a taxable Canadian discount broker account is still foreign. 

What matters is the domicile of the security, where it is registered. A mutual fund or ETF registered in Canada that holds foreign bonds or equities is still Canadian. 

Equity ETFs that avoid the T1135 rigmarole
We've sifted through the various ETF providers, like iShares Canada, BMO Financial, Horizons and Vanguard Canada who create bonafide Canadian registered funds that cover the broad passive equity indices covering the USA, Developed countries and Emerging Market countries worldwide. There are certainly many other qualifying ETFs from other providers such as First Asset, RBC, Invesco Powershares - see them all listed here on TMX Money - but we focus on the mainstream basic non-currency hedged portfolio building block funds. 

In the comparison table below, the T1135-avoiding funds are in green text. The three funds we like best within each geographic category are highlighted in green background.
(click on image to enlarge)

Note that many of the Canadian substitutes for US-registered funds have higher MERs and as a consequence have a higher tracking error i.e. tend to under-perform their respective index by a greater amount. On the other hand Canadian registered funds offer some advantages that enhance net returns, such as:
  • automatic, free distribution reinvestment;
  • avoidance of the need to exchange foreign currency since the ETF trades in Canadian dollars and handles the exchange internally much more cheaply than an individual investor can achieve (though a couple of the ETFs, ZSP-U and HXS-U, trade in US dollars in Canada on the TSX, and would thus not confer that benefit)
We did a few calculations using our free ETF comparison tool and found that the combined effects of all factors often gave quite close to the same net return for the Canadian-based and the US-based funds.

Our three favorites are:
Though it has a higher total expense load due to the combination of the management fee and the swap fee, the deferral of any tax until the investor sells shares plus the transformation of what would be annual foreign income distributions into capital gains can be very attractive in a taxable account. A Horizons fact sheet shows the benefit through a simple example.

International Developed  / Europe Australasia Far East equities - BMO MSCI EAFE Index ETF (ZEA)
The fact that it has a) a competitive MER plus, b) recovery of international non-USA foreign withholding tax by directly holding the foreign equities that is lost when a Canadian ETF holds a US-based ETF inside, is what wins for this fund.

Emerging Market equities - BMO MSCI Emerging Markets Index ETF (ZEM)
The reasons are the same as for ZEA - competitive MER plus no loss of withholding tax.

It should be noted that this fix for needing to fill in the T1135, if a person now already has assets that breach the $100k floor for reporting, cannot work immediately for a 2013 tax return, or even for a 2014 return. It can only be effective starting in 2015, since the rule is that it is the cost at any time during the year that matters, not what may be there at the end of the year. 

Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.

Monday, 3 March 2014

Tax-efficient Fixed Income for Non-registered Taxable Accounts

Some investors, especially those in high income brackets or those who save a lot, may have run out of RRSP and TFSA room, yet still want or need (e.g. because of a target asset allocation) to hold interest-paying fixed income in a non-registered taxable account. What are the options for such investments and how do they compare? A prime consideration is naturally after-tax income - which gives the best return after-tax and how much difference do the options generate? How do the options compare regarding other factors such as credit risk and interest rate risk and ease of portfolio management?

A couple of new ETFs - BMO's discount bond fund and First Asset's strip bond fund
A brand new ETF entered the scene just a few weeks ago, the BMO Discount Bond Index ETF (TSX symbol: ZDB). It holds a basket of high quality investment grade bonds whose key differentiating characteristic is a discount price to par value. That means return is partly capital gains as the bonds return to par value at maturity. On the web page of ZDB, the fact that the weighted average (of the holdings) coupon rate currently at 2.34% is less than the weighted average yield to maturity of 2.5% tells us so. (Note: The latter number is not yet posted on the fund's webpage, though the ETF's fund profile contains the 2.5% figure. BMO says the number will be posted and updated daily after the fund makes its first distribution on March 6.)

Back in June 2013, First Asset launched the First Asset DEX 1-5 Year Laddered Government Strip Bond Index ETF (BXF). It holds a basket of coupons and residuals that pay no interest; they only pay their principal back at maturity. Taxes are levied annually on the annual yield of each coupon or residual as if it were interest. The way the implicit interest is calculated and tax reported on an accruing rising basis (see explanation and example here) there is some tax efficiency in that more of the interest is reported in later years. BXF is thus a bit more tax efficient than a GIC. But it does not defer tax or pay out part of its return as lower-taxed capital gains. BXF primarily avoids the big problem today, that the vast majority of bonds are premium bonds that pay out more in interest coupons than the yield.  Canadian Couch Potato recently posted a good explanation of the discount bond benefit for taxable accounts and a review of ZDB, with links back to a previous post on BXF.

Bad Effects of Premium Bonds and Good Effects of Discount Bonds in a Taxable Account
We've taken a mix of a high interst savings account, GICs with terms ranging from one to ten years, individual bonds, the two ETFs mentioned above and as a benchmark, the iShares DEX Universe Bond Index Fund (XBB). Our comparison table below shows the results, before tax, such as would be achieved holding such investments in a registered account, and after-tax in a taxable account.
(click on image to enlarge)

Discount bonds help mostly by avoiding the premium bond penalty
ZDB and the individual discount bonds save only a little on tax compared to what the investor would pay if all the return was taxed at the rate of ordinary interest income. The green highlighted cells show a benefit of 0.04% to 0.17% extra return - not much. In contrast the benchmark XBB, which contains a preponderance of premium bonds, suffers a bigger 0.24% return penalty and one highly premium bond, the Canada 1 June 2019 maturity paying a 3.75% coupon and only yielding 1.51%, suffers even more.

Things would change if interest rates rose appreciably
It doesn't look as though interest rates in Canada are poised to rise anytime soon (2015 at the earliest, per the Bank of Canada) but if they did rise by 2% tomorrow, the advantage would shift strongly to discount bonds, as the lower half of the table shows. The ETF holdings don't change, so the coupon rate would stay quite stable in the immediate term (as we discussed in our review of XBB in a climate of rising interest rates). But the 2% risein required yield would mean that many premium bonds' falling price would make them discount bonds. XBB itself would become a discount bond fund. ZDB would even beat out after tax a GIC whose rate had gone up 2% to 5.45%.

BXF would shed its discount bond advantage much more quickly than ZDB and XBB since it only has a five year ladder and replaces about one fifth of its holdings every year, while the other two ETFs hold a vast range of bond maturities and they replace a much smaller proportion of their holdings annually. The more strongly interest rates / required yields rise, the more discount bonds there will be around and the bigger the discount, giving ZDB an increasing attractiveness.

Benefits of discount bonds vary a lot by Province
The relatively low taxation of interest in Alberta and Nunavut means that residents of those Provinces will gain much less from discount bonds than the highly-taxed residents of Quebec and Nova Scotia.
(click on image to enlarge)

After-Tax Returns not very good - most options can't beat inflation
At any maturity, our summary table of all the results shows that the best quality credit risk fixed income options provide weak returns - in most cases not even beating the latest low inflation rate of 1.5%. Only a couple of GICs do so along with one Province of Ontario bond.
(click on image to enlarge)

The GIC beats them all after tax
From the 1-year GIC on up to the 10-year GIC paying 3.45% interest, each has an appreciably higher return after-tax than any other option with comparable maturity. That's considering pure return only but there might be other reasons an investor might need or want to pick a fund instead of using GICs in a ladder.

Other considerations - GIC vs a discount bond fund

  • Rebalancing a portfolio to maintain an asset allocation easier in a fund - ETFs can be bought or sold in quantities as small as single share units while GICs are all or none, and the higher GIC rates come with non-cashable conditions. It's not possible to predict when rebalancing will need to happen, so matching GIC maturities with planned rebalancing, such as a yearly schedule will work somewhat. But the last time fixed income and equities went out of whack in a major way was during the 2008-09 financial crisis and who saw that coming?
  • Reinvesting interest / distributions easier in a fund - BMO's funds all offer automatic dividend reinvestment (DRIP) whereby distributions are reinvested in the fund at no commission cost. iShares and First Asset also offer a DRIP program.
  • GICs have CDIC coverage limits - Rock solid AAA deposit guarantees only apply on GICs up to 5 years. After that the longer term versions rely on the credit quality of the issuer, generally one of the big banks. There is also a limit of $100,000 covered per financial institution. High net worth investors may need to spread investments amongst several institutions, an inconvenience.
  • Controlling maturity and duration to match spending easier in a ladder - For investors with a definite date and intended amount of spending, using individual GICs (or bonds) can enable control of the effect of interest rate changes. The duration of any fixed income investment is equal to, or less than, its term. Recalling (explained in this post) that duration means the time at which the investor obtains the promised initial return no matter what happens to interest rates, a ladder of GICs can be adapted to planned spending. Meanwhile ZDB's duration of 6.7 years means an investor must stay invested at least that length of time to be sure of gaining the 2.5% yield to maturity. XBB's duration is about the same at 6.8 years. On the other hand, an investor in the savings phase of life with many years to planned spending may find the never-reducing multi-year duration of fixed income ETFs to be quite acceptable.
  • Diversification not really an issue - With such high credit ratings, holding a lot of different issuers, such as Provinces plus the federal government, doesn't reduce risk appreciably, it probably makes it worse. From a portfolio correlation perspective as well, GICs will be about as uncorrelated with equities as it gets. Holding an ETF with lots of bonds that have the same uncorrelation with equities but are highly correlated with each other won't help the portfolio.
Bottom Line - Discount bonds help boost after-tax returns in taxable accounts though GICs produce higher returns at the moment. In addition, the discount bond benefit is not very pronounced right now but the more interest rates rise, the greater will be the effect, especially in higher tax Provinces. ZDB will provide stronger benefits to taxable investors than BXF.

PS Thanks to reader sleepydoc for suggesting the topic.
Disclaimer: This post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation. They rest on other sources, whose accuracy is not guaranteed and the article may not interpret such results correctly. Do your homework before making any decisions and consider consulting a professional advisor.