GIC vs Tax-Advantaged Bond ETF - Which is best in a taxable account?

Situation: You have maxed out your RRSP and TFSA accounts and you want to put some fixed income in a taxable account, perhaps because your total portfolio asset allocation calls for it, or you simply want to receive the income to spend. Let's compare two options to do it, the well-known GIC against a specialized ETF oriented to this situation offering tax advantages.

1) Guaranteed Investment Certificate (GIC)

• Safety: ultra-safe, all maturities up to five years backed by federal or provincial deposit insurance
• Current rates: up to 3.15% with 2.3% readily available for a five year maturity (at BMO Investorline, we found a max of 2.45%) - see a comparison table at the Globe and Mail
• Taxation: taxed every year at the Other Income rate, the highest marginal rate, whether the interest is received in cash or paid out only at maturity - see tables of personal tax rates by province at TaxTips.ca

 2) iShares Advantaged Canadian Bond Index Fund (TSX symbol: CAB)

• Safety: relatively safe with respect to default but its complicated structure and its holdings expose it to various other risk factors, in particular interest rate risk and tracking risk, and to a lesser extent credit risk and counterparty credit risk. Interest rate risk exposes the investor to a drop in the price of CAB's units if interest rates rise. Tracking risk is higher in part because the forward contract sees TD Global Finance, the counterparty, promise only the return of an bond portfolio, net of expenses, that attempts to mimic the index. Since the DLUX Bond Index holds hundreds of different bonds and requires daily rebalancing, it is not a surprise that CAB doesn't mimic the index perfectly while incurring extra costs. Credit risk of the bond holdings is CAB's problem should it arise, though that risk is fairly low as all the holdings are of investment grade.
• Current rate: yield to maturity (YTM) of CAB is 2.14% per the iShares website but that is a gross rate subject to reduction for a management expense ratio cost of 0.33% plus other fees, especially the forward contract fee of between 0.55% and 0.75%. On top of those costs are inefficiencies and return drags that show up as extra tracking error, aka difference of performance, with CAB's target index. The estimated current yield must therefore be adjusted to about 1.2% (=2.14 - 0.33 - 0.6). Note that neither the average coupon rate for the bond holdings (3.67% per the webpage), nor the cash payout distribution yield (2.73%) is the correct rate to use in comparing the value/return of CAB against the GIC option as we explained in Fixed Income: Which is "best" - GIC, Individual Bonds, Target Maturity ETF or Traditional ETF?
• Taxation: taxed at the Capital Gains rate, which is half the rate for Other Income, despite CAB being a bond fund. Most years, cash distributions are paid out as Return of Capital (ROC), which isn't taxed at all when received, and is taxed later. This is the source of the attraction of CAB - lower tax rate plus deferral of tax.

CAB is quite complicated and its workings are well explained in a fine series of posts by Canadian Couch Potato in which he explains the structure that utilizes a forward contract, the costs and risks and how the cash payout mechanics work.

GICs offer a better return than CAB at the moment
Our comparison, based on a five year investment, shows that despite the tax advantages, the yield on CAB is too low, by almost 0.5%, to beat out GICs. The main reason is the more or less fixed costs of MER and forward fees. As our table below shows, CAB would need to yield at least 1.65% to equal GICs paying 2.45% annually. That is even assuming that taxes on CAB's returns were deferred till the end of the five years. As the Distributions tab on the iShares website shows, indefinite deferral has not been the case throughout CAB's short life since 2009 startup - its distributions in 2010 were not ROC but capital gains. The fact that a strong equity market can trigger the shift from ROC (an explanation related in Couch Potato's payout mechanics post) tells us to expect occasional future episodes of the same. (It is an interesting thing to note that BlackRock has an incentive to pick the worst stocks for the equity portfolio so that it will have no capital gains and only return of capital!) Thus CAB would need to pay out an even higher rate to compensate for taxes to be paid sooner.

If interest rates start to rise, CAB will become more competitive
The corollary of CAB's fixed costs is that as interest rates go up and CAB's yield rises, GIC s will need to provide a much bigger interest rate spread to keep ahead. We have illustrated this in the lower part of the table where GICs would need to offer 4.58% to breakeven with a net 3.0% yield in CAB. The higher interest rates rise, the more the effect of the tax rate difference. The higher your tax bracket and the higher the tax rates of your province, the greater the effect as well. To figure out the breakeven point, the above table can be used substituting the relevant current numbers.

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.