BY: STEVE HAWKINS, PRESIDENT AND CEO, HORIZONS ETFS
January 20, 2017
The recent sell-off in the bond market has created, in our view, a unique opportunity for investors to actually increase the yield of their fixed income portfolios – while also potentially reducing overall risk and their interest rate sensitivity.
Many of our clients have expressed that they are targeting an income of approximately 4% on their portfolios. The rationale for this is simple: On a $1 million portfolio, a 4% yield would generate about $40,000 of income. Typically, most fixed income investors are aiming to create an income in the 4% range with as little risk as possible. Over the past decade, this has primarily been accomplished with longer-duration bonds (i.e. buying bonds with longer maturities) – a strategy which has worked out well as interest rates have declined.
The recent sell-off in bonds that occurred in Q4 of 2016 was largely a result of a strong likelihood that interest rates would rise. Bonds with longer duration and relatively low yields (such as government bonds) fared very poorly.
While rising interest rates certainly pose a challenge for fixed income investors, this has also created an opportunity in other fixed income asset classes that are less interest rate sensitive and offer comparatively higher yields. This can include corporate bonds, Canadian preferred shares and high yield bonds. We have a number of ETF solutions that can help our clients achieve that 4% threshold with little or no increase in the total risk of their fixed income portfolio – and in some cases can actually reduce interest rate sensitivity.
The Horizons Active Floating Rate Bond ETF (HFR): The Horizons Active Floating Rate ETF (HFR) can be used as an alternative to cash and money market funds. HFR has minimal interest rate risk, but because it holds high investment grade corporate bonds, it has a higher yield than money market funds and cash. HFR currently yields about 2.15% – an attractive yield spread over equivalent cash rates in Canada. While interest rate risk is very real, corporate credit risk is not typically viewed as a concern right now. This offers a powerful way to enhance the yield of the conservative portion of a fixed income portfolio.
The Horizons Active Preferred Share ETF (HPR) and The Horizons Active Floating Rate Preferred Share ETF (HFP): The majority of Canadian preferred shares have a positive correlation to interest rates, meaning their values rise with interest rates. We’ve seen preferred shares stage a nice comeback over the last 12 months, but they still yield well over 4% and are taxed as eligible Canadian dividends. This is an easy way to enhance yield in an asset class that seems poised to perform favourably in today’s market conditions. HPR is the best performing Canadian preferred share ETF in Canada since its inception and HFP is designed to provide protection from the price impact of interest rate rises.
The Horizons Active High Yield Bond ETF (HYI): High yield bonds actually have their best historical performance during periods of rising interest rates. For the 20-year period ending December 31, 2015, high yield bonds had an average annualized return of approximately 8% during periods of rising interest rates. HYI is already up more than 15% over the last 12 months. However it’s still yielding approximately 6%. Again, with few concerns about credit risk, this could be a very compelling opportunity to generate yields that would more than offset any losses from interest rates.
The Horizons Active Global Fixed Income ETF (HAF): This is Fiera’s “best ideas” fixed income strategy, that has a global go-anywhere mandate, currently investing about 50% of the ETF’s assets in other fixed income ETFs, which enhances its transparency and liquidity. Not only does HAF currently yield about 4%, it’s designed to always have its duration lower than its yield, so that its yield can be expected to offset any losses in market value that might occur from an interest rate increase. Of course, if interest rates decrease it should see a meaningful price appreciation.
The idea behind these ETF strategies is to take advantage of a fixed income environment where credit risk is not a primary concern, but interest rate risk is. By exchanging the very real likelihood of rising interest rate risk for historically low levels of credit risk, investors have a unique opportunity to actually increase the overall yield of their fixed income portfolio while potentially reducing some of the risks of owning low-yielding, high interest rate risk bonds, such as government bonds.
It is, in our view, an effective way to get to that important 4% threshold without taking on undue risk in the portfolio.
*As at December 31, 2016.
The indicated rates of return are the historical annual compounded total returns including changes in per unit value and reinvestment of all dividends or distributions and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any securityholder that would have reduced returns. The rates of return shown in the table are not intended to reflect future values of the ETFs or returns on investment in the ETFs.
The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. All comments, opinions and views expressed are of a general nature and should not be considered as advice to purchase or to sell mentioned securities. Before making any investment decision, please consult your investment advisor or advisors. The manager and the sub advisor have a direct interest in the management fees of the ETFs, and may, at any given time, have a direct or indirect interest in the ETFs or their holdings.
Certain statements may constitute a forward looking statement, including those identified by the expression “expect” and similar expressions (including grammatical variations thereof). The forward-looking statements are not historical facts but reflect the author’s current expectations regarding future results or events. These forward-looking statements are subject to a number of risks and uncertainties that could cause actual results or events to differ materially from current expectations. These and other factors should be considered carefully and readers should not place undue reliance on such forward looking statements. These forward-looking statements are made as of the date hereof and the authors do not undertake to update any forward-looking statement that is contained herein, whether as a result of new information, future events or otherwise, unless required by applicable law.