You have to have a bit of sympathy for savers and income-focused investors — it’s really not a great time to be an income investor given the current high level of risk relative to historically low yields in fixed income strategies.
One of the cruel twists of math with fixed income investing is that declining yields technically increase the risk of investing in fixed income. Even if the credit risk of a certain type of bond (i.e., its default risk) hasn’t changed, the risk of owning the bond has increased with lower yields, since there is less of an income offset if interest rates decline or there is a sell-off in credit.
Here’s a look at the credit risk of owning high yield bonds vs. investment-grade bonds as measured by their credit spreads – that is, the excess yield they generate versus government bonds:
Source: Bloomberg, as at December 31, 2020.
These yields are extremely low on a historical basis, and could potentially leave investors subject to significant pricing risk if interest rates rise. We’ve seen some of this already, with interest rates rising during the latter end of February 2021, and the Canadian five-year bonds, for example, rising from 0.40% to approximately 0.90% during that same month.
Bond holders see the impact for every 1% rise in interest rates; in these cases, we would expect a 1% decline in the price value of the bond for every year until it matures, which is referred to as its duration. On a five-year Canadian government bond, we would expect then that the bond could lose 0.50% for every year of duration, in response to a 0.50% move upwards on interest rates. That means we anticipate that holders of those bonds lost more than 2.00% alone during the month of February 2021.
Understanding ETF Yields
Adding further confusion for investors is the fact that there is a significant gap between the current yields being reported by many ETFs (that is, the yield based on most recent distributions) versus the yield being generated by the portfolio on a go-forward basis, which is typically referred to as the yield-to-maturity.
The Current Yield for an ETF is based on the most recent distribution by the ETF and the expected annual income that would be generated by the ETF (interest or dividends) after a full year at that distribution level, divided by the current price of the security at the close of the day prior to the ex-dividend date of the last distribution. If an ETF doesn’t reduce its monthly or quarterly distributions or pays a fixed amount, the current yield can potentially be higher than what would be expected to be earned on a go-forward basis. Also, if higher income was generated from previously higher coupon payments in the portfolio, that could also mean the current yield being generated is higher than what is going to be earned going forward.
Investors can look at the yield to maturity to potentially gauge the potential yield going forward on an ETF. Yield-to-maturity (YTM) is the total return anticipated on a bond if the bond is held until its maturity, and this calculation also factors in any capital gain or loss that could result if the bond is sold at maturity. For those that hold a bond directly, this metric can be used to determine what the annual yield of the bond would be until maturity. For ETFs, it’s more complicated, since bonds are typically not held until maturity; however, it does provide some guidance of the internal go-forward yield the ETF might be earning in the future.
Effectively, if an ETF pays out a fixed payment, then the current yield can remain somewhat high while the actual internal yield, typically measured by the weighted average yield-to-maturity, can be much lower. Effectively, these ETFs may be tapping into the capital of the ETF to fund income. You might find that, come tax time, a portion of the return is actually return of capital.
This is an industry-wide issue and we have also identified this issue internally. We have an ETF where the current yield is quite a bit higher than its portfolio’s weighted average yield-to-maturity: the Horizons Ultra-Short Investment Grade Bond ETF (HFR) has a current annualized yield of 2.58% but the weighted average yield to maturity is 1.11%, as at February 28, 2021. At some point, the current yield will have to come down to reflect the lower yield being earned in the portfolio.
HFR has a current duration of 0.66 (as at February 28, 2021). It may be surprising, but, at 1.11%, HFR is actually paying a distribution rate that is quite attractive when compared to other fixed income strategies that have a duration of less than one year, making it a potentially defensive strategy against rising interest rates. However, investors could misconstrue that the strategy is going to yield 2.48%, which would put its closer to higher yield strategies. This type of risk/reward simply doesn’t exist in fixed income right now.
How Can Investors Potentially Deal with Declining Yields and Prices?
There is, admittedly, no simple answer. Investors seek to find a balance between generating a yield with a risk profile that makes sense for them. For this reason, we recommend they look at three different key areas of their fixed income strategy:
1) Credit Quality: What is the default rate on the bonds? BBB or above are considered investment-grade, while higher yields can be found in bonds that have BB or below, but the credit risk increases substantially. Keep in mind that BB yields look like investment-grade yields from only two or three years ago, so everything is relative based on current interest rates and yields.
2) Weighted Average Yield-to-Maturity: Again, this is probably a more accurate metric of what the ETF will earn on a go-forward basis. If interest rates rise, the actual yield by the ETF could end up being higher, but the YTM provides a decent baseline.
3) Duration: This reflects the interest rate risk of the strategy. The longer the duration, the likelier there could be a higher yield on the strategy; however, there could be also be a higher likelihood that losses in the value of the bonds in the portfolio could occur if rates increase.
For investors, a good course of action may be to look at all three of these metrics and find the best balance that meets their risk-return objectives. Finding a strategy with a relatively low duration, but a higher yield-to-maturity and credit rating than other offerings in its category, could be a powerful way to navigate an increasingly volatile fixed income market.
HFR Investment Objective
The investment objective of Horizons HFR is to generate income that is consistent with prevailing Canadian short-term corporate bond yields while reducing the potential effects of Canadian interest rate fluctuations on Horizons HFR. Horizons HFR invests primarily in a portfolio of Canadian debt (including debt-like securities) directly, and hedges the portfolio’s interest rate risk by maintaining a portfolio duration that is not more than one year. Horizons HFR may also invest directly in debt of U.S. companies, as well as indirectly through investments in securities of Listed Funds. Horizons HFR uses derivatives, including interest rate swaps, to deliver a floating rate of income.
Source: Horizons ETFs, as at FEBRUARY 28, 2021
**PERFORMANCE SINCE INCEPTION ON DECEMBER 10, 2010, AS AT FEBRUARY 28, 2021
The indicated rates of return are the historical annual compounded total returns, including changes in unit value and reinvestment of all 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 are not indicative of future returns. The ETF is not guaranteed, it’s value changes frequently, and past performance may not be repeated.
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