The notion that premium bonds are highly tax inefficient has been written about extensively by Justin Bender and Dan Bortolotti. In a recent blog post, Justin used his after tax rate of return calculator to demonstrate the tax efficiency of the First Asset strip bond ETF (BXF). BXF was in a league of its own in 2014 with a tax cost ratio 33bps lower than its closest peer – the tax cost ratio can be thought of as an additional MER that the investor pays in taxes. Justin compared ten short term bond ETFs, and BXF had the highest before and after tax returns of the set. The DFA Five-Year Global Fixed Income Fund (DFA231) was not included in Justin’s ETF comparison.

Unlike the ETFs examined by Justin, DFA231 is not an index fund. It is a short term fixed income fund that shifts its holdings based on changes in the yield curve, while keeping the maturities between one and five years. If the yield curve in a country is upward sloping, the fund will hold longer maturity bonds in that country as the risk of holding longer maturities is being rewarded. If the yield curve is flat, the fund will look similar to the index as there is no significant benefit to holding longer maturities. If the yield curve is inverted, the fund will hold very short maturities. The fund has the flexibility to find opportunity in yield curves around the world, and it is hedged back to the home currency (CAD) allowing global bonds to be pursued without adding volatility due to currency fluctuations. The fund, as at September 30, 2014, had just over 10% of its holdings in Canada, while more than 26% were in the United States, and Australia was also notable at 8%. DFA puts forth an effort to keep the coupons low, reducing the tax issues presented by premium bonds.

Does it work?
This fixed income strategy has been successful. In 2014, both the before and after tax returns beat out the toughest competition by a healthy margin. To be fair to the competition, DFA231 tended to have a longer average maturity and duration than both BXF and the iShares Canadian Short Term Bond Index ETF (XSB) through the year. The fund’s higher returns can be attributed to increased risk, the risk was just well compensated over this time period. It is also true that DFA231 carries a higher MER at .38% than BXF at .20% and XSB at .25%, which contributes to its lower tax cost ratio; more of its taxable distributions are absorbed by fees before they reach investors.

2014 was not the first good year
DFA231 has had a long history of outperformance and tax efficiency compared to XSB, a short term bond index fund with a ten year history available for comparison.

There is no way to determine if the strategy will continue to be this successful in the future, but it currently appears to be a tax efficient option for short term fixed income allocations.

Original post at pwlcapital.com