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My column two weeks ago about return of capital (ROC) prompted a bunch of questions from readers. You can read the column here. Also check out a primer I wrote about ROC here.

Today I'll answer some of your questions.

You mentioned that return of capital is not taxed immediately but is deducted from the adjusted cost base (ACB) of an investment. What happens when the ACB hits zero?

At that point any further return of capital distributions would not be deducted from your ACB, but would be treated as capital gains for tax purposes in the year they were received. Capital gains are effectively taxed at 50 per cent of the rate for regular income.

One of the bond exchange-traded funds (ETFs) I own – CBO – includes return of capital in its distribution. The distribution is much higher than the underlying yield-to-maturity of the bonds in the fund. To me, it looks like the ETF is inflating its distribution at the expense of the unit price, which has fallen over time. Am I getting duped here? Can a fund deliberately pay more than its earnings, continuously creating ROC?

I'll answer the second question first. Yes, an ETF or mutual fund can deliberately distribute more than it generates in interest, dividends and realized capital gains. The difference is classified as ROC for tax purposes.

Consider the iShares Canadian Financial Monthly Income ETF (FIE), which pays a fixed distribution of 4 cents monthly or 48 cents annually – equivalent to about 7.5 per cent of FIE's recent unit price. That's substantially higher than the yield of the ETF's holdings – which include a lot of bank and insurance stocks – so FIE makes up the difference by distributing ROC. In 2013 and 2014, ROC accounted for more than half of the ETF's total distributions. A consistently large amount of ROC can exert a drag on a fund's unit price over time; FIE's units are trading lower than they were at the start of 2013.

However, what's happening with CBO – the iShares 1-5 Year Laddered Corporate Bond Index ETF – is different. The first thing to note is that CBO's ROC distributions are relatively small: In 2014, ROC accounted for just 1 per cent of the total cash paid to unitholders.

So why is the fund's current distribution yield of 3.1 per cent so much higher than the weighted average yield-to-maturity of roughly 1.8 per cent for the bonds in the portfolio? The answer is a bit complex and has to do with the dynamics of bond pricing: Because interest rates have dropped in the years since many of the ETF's bonds were purchased, those bonds are now trading at a premium to their par value or issue price (for an explanation of bond pricing, read my five-minute bond boot camp online at

As those premium-priced bonds approach their maturity date, their prices are going to fall back toward their par value. In fact, you are already seeing that effect in the ETF's unit price, which has dropped gradually in recent years (there may be other factors going on as well). In effect, you are getting a fatter distribution now – generated by the bonds' coupon payments – that will be partially offset by a capital loss, such that – all else being equal – your net return will be approximately the yield-to-maturity of the bonds less the fund's expenses. So although nobody is intentionally misleading you, the lesson here is that a bond ETF's current distribution yield is not necessarily the same as an investor's actual expected yield.

When should I be concerned about the amount of ROC my fund is distributing?

The important thing to understand is that ROC is not a free lunch. If your fund's annual distribution is consistently higher than what you could reasonably expect from the dividends, interest and realized capital gains generated by the underlying securities, then you need to investigate how the fund company is making up the difference.

I have heard from many small investors who are so captivated by a fund's high distribution of, say, 7 per cent or 8 per cent, that they don't ask where the cash is coming from. In such cases, ROC usually plays a significant role. As the name implies, with ROC you are getting a portion of your own capital returned to you. This isn't necessarily the same as simply getting your original investment back, because your capital consists of your original investment plus the growth of that investment, represented by capital gains that have not yet been realized. But if you are consistently receiving a lot of ROC, it will weigh on the value of your investment. The fund's unit price won't rise as much as it otherwise would, or it could even fall.