The dex universe bond index recently sported an annual yield to maturity of 3%. Its average duration of six years means it won’t take much of a bump-up in yields to put investors in the red. Not surprising, many inves-tors are turning to alternatives in search of high yields. One popular vehicle is the “synthetic” bond fund, designed to boost after-tax returns. However, financial advi-sors must be careful to know when these funds make sense and when they don’t.
Synthetic bond funds enter into forward agreements with banks to gain exposure to bonds. The synthetic fund invests directly in a basket of non-dividend-paying Canadian stocks while the bank invests in a bond portfolio (or some reference fund of the synthetic fund’s sponsor). The forward agreement is simply a legal contract requiring the fund to swap its return on stocks for the bank’s return on its bond portfolio. Voilà! The fund earns bond returns without generating interest income and without buying a single bond. (See story on page 36.)
The mutual fund sector has launched many synthetic bond and income funds over the past couple of years. Advisors, however, must look through the marketing material to determine these products’ worthiness. Key to this assessment is understanding that the management expense ratio excludes the cost of the derivatives used by these funds — typically, 0.3% to 0.4% annually. These funds are beneficial to the extent that expected tax savings can exceed the synthetic fund’s additional costs.
The higher the pre-tax yield and the higher the client’s tax bracket, the greater the synthetic fund’s tax benefits.
One fund company recently launched two synthetic bond funds — one global and one short-term. The global bond fund boasts a yield to maturity of 5.6% and is likely to sport a 2.7% MER. This fund’s net pre-tax yield of 2.9% is taxed as capital gains — resulting in an expected after-tax yield of 2.2% at Ontario’s top marginal tax rate. The “reference fund” has a 2.23% MER and the same yield, but I estimate its after-tax yield to be 1.8%, thanks to harshly taxed interest income. While a net 2.2% yield is no head-turner, score one for the synthetic fund.
The short-term synthetic bond fund’s potential tax benefit, however, is much less because the yield to maturity of its reference fund is only 2.2%.
The cost of the synthetic fund’s forward contract exceeds its expected tax benefit, making this firm’s traditional short-term bond fund the better deal. Accordingly, I see no reason for this new synthetic fund’s existence — other than to bring in new money for the sponsor.
As yields and tax brackets change, this analysis must be updated periodically to ensure that clients are getting the biggest bang for their bond bucks. And use synthetic funds only when a clear and sufficiently large tax advantage exists. After all, synthetic funds involve counterparty risk. Although the risk of a big Canadian bank failure is admittedly low, it’s not zero. Clients should be compensated for this risk accordingly. IE
Dan Hallett, CFA, CFP, is director, asset management, for Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for advisors, affluent families and institutions.