The Best Tax Efficient Bond ETFs for Canadian Investors

When I speak with investors in the United States, I am often struck by how front and center tax planning is in their portfolio construction. You see it most clearly in the municipal bond market.

There are ETFs exempt from federal tax, funds structured to avoid the alternative minimum tax, and even state-specific municipal ETFs for investors in high-tax jurisdictions like California and New York. On top of that, there are leveraged municipal closed-end funds offering elevated tax-sheltered yields.

Canada is different, and part of that is structural. Canadians have relatively generous registered account options, including the Registered Retirement Savings Plan (RRSP), the First Home Savings Account (FHSA), and especially the Tax-Free Savings Account (TFSA).

Still, some investors do max out their registered room. Once that happens, any additional investing must occur in a non-registered account, where interest income, dividends, and capital gains are all taxable.

In Canada, capital gains and eligible dividends receive preferential treatment. Interest income, including bond coupons and distributions from real estate investment trusts (REITs), is taxed at full marginal rates.

That creates a challenge for more conservative investors who need bonds to manage volatility but want to hold them in a taxable account. Traditional bond ETFs are often tax-inefficient in this setting.

Today, I am looking at two Canadian bond ETFs that take a different approach and can be more tax efficient than standard bond funds, from Global X Canada and BMO Global Asset Management.

BMO Discount Bond Index ETF (ZDB)

A discount bond is a bond that trades at a price below its face value, typically because its coupon rate is lower than prevailing market interest rates.

For Canadian investors, discount bonds can be more tax efficient than premium bonds. That is because a greater portion of the total return comes from capital appreciation as the bond pulls toward par at maturity, rather than from coupon income. In a non-registered account, capital gains are taxed more favourably than interest income and can be deferred until the bond is sold.

The challenge is access. Fixed income trading in Canada is over the counter, opaque, and less liquid. Identifying true discount bonds requires evaluating yield to maturity, coupon rates, duration, and credit quality across hundreds of individual issues. For most retail investors, that is not practical.

A more accessible solution is ZDB which tracks the FTSE Canada Universe Discount Bond Index. The index screens for bonds with a coupon rate equal to or less than 1.4 times the yield to maturity of the security. In plain terms, ZDB selects bonds that are attractively priced below par.

Structurally, the portfolio composition looks similar to a broad Canadian aggregate bond ETF. It holds federal government bonds, provincial bonds, and investment-grade corporate bonds rated BBB or higher. The holdings are market-cap weighted and rebalanced quarterly.

The current annualized distribution yield sits at approximately 1.72%, which appears low compared to traditional bond ETFs. That is by design. With a discount bond strategy, more of the expected return comes from price appreciation rather than coupon payments. In a taxable account, that allows investors to defer taxation by simply holding the ETF and not realizing gains.

That said, ZDB is not risk free. Credit risk is relatively contained, given its investment-grade mandate and meaningful exposure to A, AA, and AAA-rated issuers. The more material risk is duration.

With an average duration of roughly seven years, the ETF is moderately sensitive to interest rate changes. Rising rates would pressure prices. Falling rates would benefit them.

All of this comes at a very competitive 0.10% expense ratio, making ZDB one of the most cost-effective ways for Canadian investors to hold bonds in a non-registered account while improving tax efficiency.

Global X Canadian Select Universe Bond Index Corporate Class ETF (HBB)

Our second pick HBB takes a completely different approach. It does not actually hold any underlying bonds, despite tracking the Solactive Canadian Select Universe Bond Index (Total Return).

From a portfolio standpoint, HBB provides Canadian aggregate bond exposure. The index includes federal, provincial, and investment-grade corporate bonds, with an average credit quality of AA. Duration is similar to ZDB at 7.27 years, meaning the ETF is moderately sensitive to interest rate changes.

The “total return” part is key. Instead of buying bonds directly, the ETF enters into a total return swap agreement with a counterparty. HBB pays a swap fee and in exchange receives the total return of the underlying bond index. This structure offers two major advantages.

First, it minimizes tracking error. Because the ETF is contractually receiving the index’s total return, there is little slippage from cash drag, trading frictions, or imperfect reinvestment of coupons.

Second, since HBB does not physically hold bonds, there are no coupon payments flowing through to investors. Everything is embedded in the swap’s total return calculation.

HBB is also structured as a corporate class fund, meaning it is a share class of a mutual fund corporation. Within that structure, gains and losses across different share classes can offset one another, which can reduce or even eliminate taxable distributions at the fund level.

In a non-registered account, this means HBB has not historically paid monthly interest distributions like most bond ETFs. Instead, the value compounds inside the ETF NAV, and taxes are deferred until you sell and realize a capital gain. That is the primary appeal.

Of course, this is not a free lunch. The swap fee of up to 0.30% annually is an additional cost layered on top of the stated 0.10% management expense ratio. There is also a trading expense ratio of about 0.29%. All in, the effective cost is higher than a straightforward discount bond ETF like ZDB.

There is also counterparty exposure. This figure represents the net amount owed to or from the ETF’s swap counterparties as a percentage of net assets. If the number is negative, the ETF has excess collateral posted and effectively owes its counterparty, implying zero counterparty risk.

If the number is positive, the ETF is owed money by the counterparty. Currently, HBB’s counterparty exposure stands at 10.73%, which is negligible. Global X uses major Canadian banks as swap counterparties, which further reduces (but does not eliminate) risk.

In short, HBB sacrifices simplicity and adds swap complexity in exchange for tax deferral. For investors in high tax brackets holding bonds in a non-registered account, that trade-off can be worth considering.