Since the beginning of the COVID-19 pandemic the fixed income asset class has not been as attractive to investors, as evidenced by lower historical returns throughout the period and in-flows, compared to stimulus-driven equity market gains.
However, the recent stock market downturn could shift investor interest back towards the fixed income market in an effort to preserve capital while weathering this latest bout of market volatility.
Yet, with looming rate hikes also signalled by the U.S. Federal Reserve, the Bank of Canada and other central banks across the world, there could be more frustration ahead; particularly for fixed income investors with long-term bond exposure.
For investors seeking a potentially greater risk/reward trade-off as part of their fixed income approach in 2022, the Horizons Active Ultra-Short Term Investment Grade Bond ETF (HFR) might be worth a consideration.
As an ETF, HFR is effectively neutral on rate increases and could see its yield rise without the impending pain of capital losses that other long-term bond ETFs could suffer. Consequently, the Horizons Cash Maximizer ETF (HSAV) and the Horizons High Interest Savings ETF (CASH) could also benefit from potential rate hikes but at a much lower yield threshold, compared to HFR.
In the blog below, we’ve sought to describe some of the key reasons why short-term duration bond ETFs like HFR can offer better protection. We’ve also included a number of comparisons to other Canadian-listed fixed income ETFs with longer durations or lower yields which may be more impacted by a deluge of policy rate hikes in 2022.
Risk and Return: Is Your Duration Short-Enough?
There is a general consensus among many fixed income analysts that interest rates should rise in 2022, barring any significant surprises that could derail inflationary pressures in the wider global economy. The response for some investors has been to move their fixed income allocation into lower-duration ETFs, which on average hold shorter maturity terms in their portfolios.
Increasingly, this is becoming a very crowded fixed income trade, and the potential risk/reward profile of going short on duration may not be that beneficial. In most cases, owning bonds with durations between two and three years is, currently, a potentially poor risk/reward trade off. This is because the yield relative to the current interest rate risk isn’t much different than owning higher duration bonds.
Let’s take a look at the current interest rate curve on Canadian bonds. It shows a clear picture of the challenge that investors are facing when determining “How short is short enough?” to generate protection against rising interest rates.
Generally, the potential risk-reward trade-off on longer duration bonds can be relatively poor. Standard duration math suggests that for every year of duration for a fixed income security, an investor can typically anticipate the loss of 1% of capital for every 1% rise in interest rates.
In this case, investors are only being compensated about an additional 20 basis points (bps) to own a two-year bond versus a one-year bond. Even on one-year bonds, investors could still expect to see a capital loss if rates moved more than 1%. Duration management has arguably never been so important in a market where interest rates are rising precipitously.
The chart below compares the Canadian government yield as at December 31, 2020 and December 31, 2021.
Source: Bloomberg as at December 31, 2021
This potentially poorer risk/reward trade-off has forced many investors to move to the ultra-short end of the curve, and while six-month rates started 2022 at around 0.40%, they are now hovering around 0.60% in anticipation of drastic rate increases (Source: Bloomberg as at January 21, 2022).
Many major Canadian banks have raised interest rate targets for 2022: Scotiabank has a target in excess of a 1.25%1 rise in the overnight rate in 2022, TD Bank has a forecast of 1.25%2 and RBC has a 1.00%3 target.
Horizons ETFs’ key fixed income sub-advisor, Fiera Capital, has a target of between 1.00% and 1.75%, depending on the amplitude of inflation. Based on current yields, we would anticipate that any fixed income strategy with a duration greater than two years would likely continue to face performance challenges unless they moved farther out on the credit curve – that is, moving more into BBB or below rated bonds.
In the higher quality investment grade space, it will likely be very difficult to navigate this rate environment.
Being ultra-short duration (bond or fixed income strategies with less than a year) has been one of the most reliable ways to ensure that a fixed income portfolio can generate positive returns.
This chart shows investors that the difference between a one- and two-year bond, at the end of 2021, was only 20 bps. Just as startling, the difference between a five- and 10-year bond was almost the same. 10-year bonds are effectively compensating investors the same as five-year bonds, despite having double the duration risk, with the same being true for one- and two-year bonds.
Source: Bloomberg, as at December 31, 2021
Investors could look at these two charts and possibly surmise that the best way to deal with the rising rates is to hold ultra-short duration bonds. The challenge is that despite yields rising, this is still a very low yield part of the curve.
Most fixed income ETFs that have less than a year in duration are likely to yield less than 1%, whereas ETFs in the two-to-three-year range should have slightly higher yields but have been negatively impacted by duration.
One ETF strategy that has held up extraordinarily well in this environment is the Horizons Active Ultra-Short Term Investment Grade Bond ETF (HFR), which was one of the best performing ETFs in its category in 2021 (according to Morningstar Direct)4 with a 0.83% return vs. a median -1.01% return for the short-term fixed income category.
What makes HFR so well structured for this market environment is that it’s able to provide ultra-short duration exposure while maintaining a higher yield due to its ability to harvest an attractive corporate bond premium from its underlying holdings.
HFR will typically own a portfolio of higher investment grade mid-duration Canadian corporate bonds. The ETF will eliminate the majority of the interest rate risk of owning these bonds by entering into a fixed-for-floating interest rate swap. The ETF will pay a fixed rate in exchange for receiving the Canadian Dealer Offered Rate (CDOR). As at January 21, 2022 the three-month CDOR rate is around 0.75%.
Current Key Details on HFR
1) HFR is a high investment-grade corporate bond strategy (average credit rating of BBB+)
2) HFR reduces the interest rate risk (duration) of the portfolio through the use of interest rate swaps on the underlying portfolio of bonds. This swap earns the Canadian Dealer Offer Rate (CDOR)
3) As the CDOR rises, the value of the underlying bonds in each ETF portfolio is expected to decline in value. However, the value of the swap is expected to increase, meaning the market value of the ETF is expected to see minimal change. Nevertheless, the yield of the ETF should increase. Conversely, if the CDOR drops, the opposite is expected to happen with the yield of these ETFs ultimately declining
4) HFR has a current yield5 of approximately 1.47%. The excess yield from HFR is generated from the spread of the corporate bonds it holds above the fixed rate the ETF pays
If we look at three key factors, HFR offers a strong risk reward trade-off by offering an attractive combination of yield, credit quality and low duration.
According to Morningstar, the average yield to maturity in the short-term fixed income category is 1.31% with an average duration of 2.5 years. In order to effectively generate a positive return in 2022, a short-term fixed income ETF will likely need to have a yield to maturity that exceeds its duration, if rates move between 0.75% and 1.25% in 2022. ETF mandates with a higher duration than yield would be expected to lose about 1% for every year of duration which means they could suffer total return losses in the portfolio in 2022.
Below shows HFR’s key metrics and where it should be well positioned for a rising interest rate environment while also maintaining an investment grade rating.
Horizons Active Ultra-Short Term Investment Grade Bond ETF (HFR) Key Metrics
Source: Morningstar as at December 31, 2021
Below is a selected group of competitors in the Canadian Short-Term Fixed Income category that have been selected based on relatively high assets under management. In 2021, HFR outperformed amongst this group of competitors on a one year basis.
|BMO Ultra Short-
Term Bond ETF
Short Term Corp
Corp Bond ETF
Term Bond ETF
Term Bond ETF
Source: Morningstar and ETF provider websites as at December 31, 2021.
HFR’s primary risk versus these competitors is its reliance on corporate credit, but we view this as a net benefit more than a detractor for this ETF in 2022.
The reason this trade makes sense right now is there is not a lot of analyst concern about corporate defaults, so while these spreads are low by historical standards, they can remain in this range for quite a long time – keep in mind we’re likely in the midst of a rising interest rate environment. Earnings remain strong for corporate earning and default risk is relatively low. Investors can use this to their potential advantage with a strategy like HFR that can generate a higher net yield on short-duration versus government strategies.
As a result, the risk of interest rates rising probably supersedes corporate default risk at this point in the credit cycle.
In this blog, we’ve sought to describe some of the key reasons why short-term duration bond ETFs, like HFR, can offer better protection versus longer duration bond ETFs. Perhaps you’re looking to weather equity market volatility or just looking to reallocate your fixed income exposure for 2022. Whatever your reason, by using HFR, you could potentially benefit from the higher yield from corporate credit while reducing interest rate risk.
5As at December 31, 2021
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The Horizons Cash Maximizer ETF (“HSAV”) uses cash accounts and does not track a traditional benchmark but rather a compounding rate of interest paid on a cash deposit that can change over time. Any distributions which are received by HSAV are reflected automatically in the net asset value (NAV) of HSAV. As a result, the shareholders of HSAV are not expected to receive any taxable distributions
If HSAV/HSUV.U experience a significant increase in total NAV, the Manager may, at its sole discretion and if determined to be in the best interests of shareholders, decide to suspend subscriptions for new ETF shares of either ETF if considered necessary or desirable in order to manage potential tax implications and/or to permit the ETF(s) to achieve, or continue to achieve, its(their) investment objective(s). During a period of suspended subscriptions, if any, investors should note that ETF shares of HSAV/HSUV.U would be expected to trade at a premium or substantial premium to the NAV per ETF Share of HSAV/HSUV.U. During such periods, investors are strongly discouraged from purchasing ETF shares of HSAV/HSUV.U on a stock exchange. Any suspension of subscriptions or resumption of subscriptions will be announced by press release and announced on the Manager’s website. A suspension of subscriptions, if any, will not affect the ability of existing Shareholders to sell their ETF Shares in the secondary market at a price reflective, or potentially higher than, the NAV per ETF Share.
HFR – The investment objective of the ETF is to generate income that is consistent with prevailing short-term corporate bond yields while stabilizing the market value of the ETF from the effects of interest rate fluctuations. Horizons HFR invests primarily in a portfolio of Canadian debt securities and hedges the portfolio’s interest rate risk to generally maintain a portfolio duration of less than one year. Horizons HFR may also invest in debt securities of U.S. companies, directly, or through investments in securities of other investment funds, including exchange-traded funds. Horizons HFR uses derivatives, including interest rate swaps, to deliver a floating rate of income. Horizons HFR, to the best of its ability, seeks to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.
XSH – The ETF seeks to provide income by replicating, to the extent possible, the performance of the FTSE Canada Universe + Maple Short Term Corporate Bond Index, net of expenses. Under normal market conditions, XSH will primarily invest in Canadian fixed income securities.
ZCS – The ETF tracks the FTSE Canada Short Corporate Bond Index, which includes investment-grade corporate bonds denominated in Canadian dollars with between one and five years remaining until maturity. Qualifying issues must be fixed-rate and have at least $100 million in outstanding face value. The index is market-value-weighted.
ZST – The ETF seeks to provide exposure to a variety of fixed income securities with a remaining effective term to maturity of one year or less. The ETF will primarily invest in money market instruments and directly in fixed income securities, including corporate, Government of Canada, provincial and municipal bonds. The ETF may invest in floating rate instruments, floating rate preferred shares and other floating rate securities, subject to the rate reset date being no greater than one year and the term being no greater than five years.
FCSB – The ETF aims to provide a steady flow of income. It invests primarily in Canadian fixed income securities, usually with an average term to maturity of five years or less. It can invest in these securities either directly or indirectly through investments in underlying investment funds.
QSB – The ETF seeks to replicate, to the extent reasonably possible and before fees and expenses, the performance of the Solactive Canadian Select Short-Term Bond Index, or any successor thereto. It invests primarily in Canadian investment grade bonds.
TERM – The ETF seeks to earn the highest level of income consistent with the preservation of capital by investing primarily in a diversified portfolio of short-term fixed income securities issued by Canadian corporations and may also invest in short-term fixed income securities issued by federal, provincial or municipal governments in Canada. In order to achieve its investment objectives, the fund invests mainly in short-term Canadian corporate investment-grade fixed income securities.
VSB – The ETF seeks to track, to the extent reasonably possible and before fees and expenses, the performance of a broad Canadian bond index with a short-term dollar-weighted average maturity. Currently, this Vanguard ETF seeks to track the Bloomberg Global Aggregate Canadian Government/Credit 1–5 year Float Adjusted Bond Index (or any successor thereto). It invests primarily in public, investment-grade fixed income securities issued in Canada.
XSB – The ETF seeks to provide income by replicating the performance of the FTSE Canada Short Term Overall Bond Index™, net of expenses.