After more than a year of continuous interest rate hikes from the Bank of Canada and the U.S. Federal Reserve, investors have gravitated towards cash alternatives to capture the yield from rising rates, while waiting out inflation and market volatility.

To discuss this increasingly popular asset class among Canadian investors, Mark Noble, Executive Vice-President, ETF Strategy, and Alek Riley, Associate Portfolio Manager, and ETF Product Specialist, dive into the objectives and use cases for the newly launched Horizons 0-3 Month Canadian and U.S. T-BILL ETFs, CBIL and UBIL.U.

In this transcribed conversation, Mark and Alek discuss how CBIL and UBIL.U can fit in portfolios, how they can be used to potentially improve fixed-income allocation risk dynamics, and why they could be an attractive cash alternative for today’s uncertain market landscape.

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Cash: a popular asset class

Mark Noble:

I think a lot of people consider cash, particularly up until recently, as really a form of capitulation. We viewed cash as an exit from the market, not as a performance asset class. It’s where you went when things were going poorly. But actually in 2022, if you had owned cash, and here we’re using our example of our Horizons High Interest Savings ETF (CASH), you were generating strong positive returns relative to the performance of most other asset classes.

What you can see here is in 2022, most asset classes, Canadian equities, Treasuries, REITs, and even Bitcoin had negative returns and fairly sizable negative returns when you were looking at three asset classes, crude oil, gold, and cash, as positive generators of return for your portfolio. I think this has been one of the reasons, beyond the rising interest rates, that a lot of investors have been hugely brought to this category. Alek, I’m hoping you can provide a little bit more context behind the reason for this.

Alek Riley:

I think it’s a couple of things, Mark. The first thing that we want to highlight, to your point, is how large the inflows have been in this product lineup. What we’ve seen has been frankly in many ways unprecedented, both in Canada and increasingly in the U.S. too.

These ETFs – they started relatively recently – and really, they’ve grown at a very fast pace; well over $10 billion in Canada in the last year in the High-interest Savings Account (HISA) ETFs. And numbers, while similar, are even higher in the United States.

What you’re looking at on this chart is the Canadian Ultra Short Term in High Interest Savings Accounts (HISA) ETFs combined assets under management (AUM) on the left side, and then the right side shows the flows.

The assets under management (AUM) now are well over $20 billion. Many investors have taken an interest in these ETFs, and I think the ETFs that we’re going to talk about today, fit into this well and are complimentary.

To your point about what’s driving this, I would say it has to do with the level of inversion in the yield curve. It has created some unique characteristics in fixed income.

Particularly, what this chart shows is the yield on the left side, and then on the bottom here is the standard deviation. We use the standard deviation of returns because we wanted to be able to highlight both interest rate risk, by looking at longer-term government offerings, and then also looking at credit as well.

I think what’s fascinating, and why these ETFs have seen such an interest both in Canada and the U.S., is because from a risk/reward perspective if you look here at the 1-3-month U.S. T-Bill index, what you have here are yields over 4%. And, really, the only place you’re getting a better yield than that is in high-yield bonds and maybe a little bit in the corporates, but it’s a marginal increase for quite a bit more risk by historical standards.

Mark Noble:

What you’re showing here is it’s a little bit of a risk trap, in that you’re getting the same return, but the risk variance across all of these fixed-income asset classes is quite a bit different as that standard deviation chart shows. I think what we’ve seen is that with the 1-3-month U.S. T-Bills, these are probably providing the most attractive risk/reward profile on this fixed-income spectrum. This is probably why – no surprise – we’ve been very keen to launch products that give investors exposure to this risk/reward profile. And those would be the Treasury Bill ETFs that you’ve been developing on our behalf, Alek, and I’m hoping you can go through those right now.

Why should investors consider T-Bill ETFs?

Alek Riley:

Before we get into the products, T-Bills are something that has been neglected I would say for quite a while because, for the longest time, they haven’t offered any yield. But, due to the accelerating hiking cycle that we’ve seen, now there is a yield, as we’ve talked about.

We’re almost learning about T-Bills again for the first time. The main points to hit are that T-Bills are issued by their respective federal governments for their financing needs.

Unlike most other fixed-income instruments, they’re issued at a discount to face value. And then as they mature, they’re pulled to par and you receive that face value. The last piece in terms of T-Bill mechanics is that neither the Canadian nor U.S. government has ever defaulted on their debt obligations. These are seen as being among the safest underlying investments that you can make from a portfolio perspective.

The last piece to highlight is that if you look at T-Bill rates, the two charts here show the 3-month T-Bill rate for Canada and the 3-month T-Bill rate for the U.S., as well as their respective central bank policy rates. The T-Bill rate tends to increase and fall with the prevailing interest rate environment. And that makes intuitive sense. I think that’s part of the reason why when you look at the rapid increase in interest rates, we thought there was a great opportunity to launch these two ETFs.

Mark Noble:

And the risk/reward profile is very interesting here because we typically use the three-month T-Bill to calculate the risk-free rate. There’s no risk-free return in investing, but what you’ve highlighted there is that investors are compensated now for an area of the market, which probably offers the lowest risk profile.

Alek Riley:

For sure.  I think that’s why these products are well-positioned right now. Just quickly going through some of the product details:

The two ETFs are, as you mentioned earlier, CBIL and UBIL.U, the Horizons 0-3 month Canadian and U.S. T-Bill ETFS. You can see the details on the website. Something to keep in mind about both products, the Canadian version and the U.S. version, is that they generally invest in T-Bills with maturities that are generally less than three months.

In terms of the management fee, you’re looking at basically 10 basis points (bps) for the Canadian version and 12 bps for the U.S. version. I want to note as well that the U.S. version trades in U.S. dollars, which is an important consideration. We’ve also highlighted the yield of both of these ETFs, which we’ll talk about as we go forward.

*Initial Target Annualized Net Yield : The amount of the monthly distributions of an ETF, and therefore the initial targeted annualized net yield and the ongoing annualized net yield of an ETF, may fluctuate based on market conditions, including changes to interest rates. There can be no assurance that an ETF will make any distribution in any particular period or periods. The Manager may, in its complete discretion, change the frequency of these distributions, and any such change will be announced by press release.
***Plus applicable Sales Tax.

Horizons High Interest Savings ETF (CASH): differences, benefits, and considerations

Mark Noble:

Another ETF that we offer in this cash spectrum, but isn’t based on policy rates with the T-Bills, is our Horizons High Interest Savings ETF, which is currentlyas at April 20, 2023, yielding 4.95% on a gross basis and then minus the 10 bps management fee, so 4.85% yield. But the thing that we need to highlight is that we didn’t launch the T-Bill ETFs with the idea of trying to replace HISA ETFs. What we’re highlighting today is that there’s a little bit of a different risk spectrum in terms of how they work.

*Estimate Annualized Yield: An estimate of the annualized yield an investor would receive if the most recent distribution rate stayed the same for the next twelve months, stated as a percentage of the net asset value per unit on the date before the ex-dividend date of the current distribution.
**Plus applicable Sales Tax.

With the HISA ETFs, a lot of investors are probably not aware of the fact that the yields set by the HISA ETFs are set by the key large banks, which set the rates based on a plus or minus margin versus the overnight rate. Certainly, their offerings are similar to the T-Bill ETFs, such as the ability to rise as policy rates go up or down or go up in the case of them increasing. However, they are still set by the banks.

That means that there could be a divergence that occurs between what is offered by the banks and what is potentially offered by the policy rates on the T-Bills.

Where do CBIL and UBIL.U fit on the risk spectrum of cash alternatives?

Alek Riley:

There are a lot of similarities between these different categories in that they’re all considered relatively safe investments, but there are some subtle differences as you’ve indicated.

First, to start with the similarities, if you look at both the HISA ETFs and the T-Bill ETFs, both are ETFs, which means they can be bought and sold at any point during a trading day. They’re highly liquid. And also, as you mentioned earlier, the yields are expected to rise and fall with whatever that prevailing interest rate environment is.

When you compare that against say a GIC, which typically carries a fixed term with an interest rate that is set at the beginning of that term, there is a stark contrast to the T-Bill and HISA ETFs. There are also some differences between the T-Bill and HISA ETFs that I think matter as well that you’ve highlighted. The first is, in both the GICs and HISA ETFs, the underlying investment is with Schedule 1 banks. Now that’s not the government. The T-Bill ETFs on the other hand, the underlying constituents, that’s government T-Bills. They’re backed by the full faith and credit of the respective government. And that means that in the case of T-Bill ETFs, CDIC insurance isn’t applicable because the respective issuer is the government.

One of the things that have been an obstacle in some cases for the HISA ETFs is that they’re not CDIC insured, but the T-Bill ETFs carry the highest quality. When you’re looking at these funds on a relative basis, even though the yield might be a little bit lower than say a HISA ETF, the divergence between GIC rates and where interest rates are right now would probably be quite surprising to many investors in comparison to T-Bill ETFs.

Mark Noble:

Alek, you mentioned the yield curve at the start of the presentation. Just for those of you not familiar, the yield curve is talking about where yields are on a multi-year period. Historically, longer-dated yields, that is 5-10 years, would have a higher yield than shorter rates. And as we mentioned earlier, the cash ETFs, like CASH or the HISA ETFs, are based on the rate being offered by the banks.

We are already seeing that, at least on the GIC side, rates on the longer-dated GICs have started to move down because of this yield curve inversion. This suggests, again, that there can be a difference between the policy rates that are offered by T-Bills and what are offered by the banks.

Alek Riley:

I think that highlights that there are only a few GICs that have a higher yield than what you’re getting on T-Bills. I think that accentuates the point that you just made. The big question now is why should you choose T-Bills and why should you choose T-Bill ETFs.

There are a couple of reasons that we’ve highlighted, and the first and most important one by far is safety. The underlying holdings are backed by their respective governments, making them among the safest investments you can make.

For risk-averse investors, this is a good place for them to feel comfortable parking cash because they don’t need to worry necessarily about the underlying credit quality or be subject to any kind of credit risks that you might see in other savings vehicles.

I would also say there’s another use case here, which is not necessarily just as an alternative savings vehicle, which is what you might associate a HISA ETF, a GIC, or even an internal savings account with, and that is the fact that these are ultimately fixed income ETFs at the end of the day. What that means is that for an asset allocator or a discretionary Portfolio Manager, what these ETFs provide is opportunity.

What I mean by that is you have the opportunity to take risks in other areas of your portfolio knowing that you have an allocation to an asset class that historically has been seen as being risk-off. That is useful because you can be more tactical and leverage your expertise and edge without necessarily needing to be constrained by certain risks elsewhere. The reason why you can do that is because of these competitive rates. You can feel comfortable sitting in this cash alternative and using that in a barbell or extreme barbell to pick up yield or return elsewhere and leverage your tactical views.

Mark Noble:

Amazing, Alek. It just goes back to suggesting that you’re now being compensated to be conservative, and that’s something that hasn’t existed before.

Q&A

Do these ETFs hold T-Bill futures or do they hold the underlying T-Bills?

CBIL and UBIL.U respectively hold between 6 to 8 T-Bills each, at any given time. The analogy is that it’s almost like an escalator. At the top of the escalator are longer-dated T-Bills, which are generally less than three months. And then as you go down the escalator, there are T-Bills that are nearing maturity.

That balance means that over time, with subscriptions to the ETF and maturing T-Bills, we are able to replenish, if you will, the “term to maturity” on the portfolio.

The goal here is that the funds hold the underlying T-Bills, and maintain a target duration within a band. The benefit of that is you get to maintain and ensure your reinvestment risk and your pricing risk are balanced.

This is beneficial, because if an investor was to buy a single T-Bill, as an example, and interest rates move up, then the investor is now waiting before reinvesting at higher rates. Whereas sticking with this escalator analogy, investors are always getting the opportunity to reinvest depending on the changing interest rate environment.

In the case of these ETFs, our holdings are available on the website every day, so you can always see what the ETFs are holding.

How do the T-Bill ETFs compare to the HISA ETFs? When or where would these be used relative to a HISA ETF?

The reason for launching these products wasn’t because we thought that there was something wrong with HISA ETFs.  HISA ETFs have been an extraordinarily successful ETF class. Our ETF, CASH has been very successful. The benefit of CASH is that it’s an alternative savings vehicle that’s liquid. The difference is the HISA ETFs are trying to maximize yield, while the T-Bill ETFs, the primary function is safety.

When you think about it in that way, you understand that the point of that is so you can feel comfortable taking risks elsewhere. And, if your concern is that the yield on the T-Bill ETF, for example, is too low, there are lots of other opportunities where investors can increase the yield on a portfolio level without substantially increasing risk.

Will the distribution be treated as a dividend or interest income?

The tax treatment is still an interest income.

Are these ETFs similar when it comes to taxes for a Canadian when compared to US Treasury 3 Month Bill ETF (TBIL) in the U.S.?

It would be the same because it’s interest income; it would be foreign interest income. They’re both taxed at your highest marginal tax rate, whether it was TBIL or CBIL.

In terms of UBIL.U versus the Horizons US Dollar Currency ETF (DLR), how is UBIL.U different?

The difference is that DLR, while under the current interest rate environment, has benefited from increasing interest rates.  The key purpose of DLR is as a currency tool, first and foremost. DLR trades in both Canadian and U.S. dollars, and it can be used as a currency conversion tool, whereas UBIL is an asset class or alternative savings vehicle and not a trading tool.

Would we expect a bid-ask spread and what would that be?

Under normal market conditions, we would not expect or anticipate the spread to be wide. If it’s any comfort right now, if you look at both ETFs, they’re trading at one cent wide. We would generally anticipate that the spread will stay relatively tight. I think investors can feel comfortable knowing that.

Again, that has to do with the low spread on the underlying investments themselves. If you invest in really liquid securities, you’re going to have a very liquid ETF. That’s the same case here.

Would we hedge against USD/CAD rate on UBIL.U?

No, because we don’t offer UBIL.U in Canadian dollars. There’s no hedged version of that. UBIL.U would be purchased in U.S. dollars, and then they’ll be ideally then for a U.S. dollar account.

You could purchase that in CAD, but then you would take the currency conversion. The ETF itself is denominating U.S. dollars, which means there is no hedging occurring in these products.