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ETFs in the Era of Fiscal Expansion

2017.jpg 

BY: STEVE HAWKINS, PRESIDENT AND CEO, HORIZONS ETFS

December 22, 2016

Canadian ETF investors need to be prepared for what could be a seismic shift in the world of investing. It is being spurred by the anticipation of “fiscal expansion”, which is the new form of stimulus replacing the era of monetary policy and quantitative easing that has dominated markets for the last eight years.

Governments are now getting into the business of direct stimulus programs, tax cuts, corporate tax incentives and infrastructure spending. Further, we have to be fully aware of the effect that Donald Trump could have – which we expect may be the implementation of one of the largest coordinated stimulus spending programs in modern history.

This has dramatically changed the outlook for most major asset classes:

  1. It has led directly to an inflationary environment: rates were already rising going into the fall, but the election of Trump has accelerated this trend and has resulted in the worst global bond sell-off in the last 25 years. Yields on Canadian 10-year bonds, for example, have risen roughly 75 basis points, as at December 15, 2016.
  2. Equity values have taken off due to the expectation that corporate profits should get a boost from fiscal expansion.

Fixed Income ETF Trend – Inflows Starting to Slow

The immediate concern for most Canadian ETF investors is fixed income. This has been a growing allocation for Canadian investors:

  • • Nearly 42% of Canadian ETF inflows in 2016 went into fixed income1
  • • Canadian fixed income is now the single-largest asset class for Canadian ETF investors. In Canada, more money is invested in Canadian fixed income than Canadian equities (34% versus 32%)1
  • • A potential problem with this is that the duration on fixed income ETFs is relatively high. For instance, the duration on the Horizons Cdn Select Universe Bond ETF (HBB) is seven years, which is about on-par with the other broad investment-grade bond ETFs containing the bulk of fixed income assets. Generally, you can expect to lose approximately 1% of return per year of duration with every 1% rise in interest rates. This means a 50 basis points rise in this space could be expected to generate about a 3.5% loss. That’s higher than the current yield on these products, which is about 3%

1 Source: National Bank, as at December 9, 2016.

Shortened Duration

  • • Buying short-duration bonds has already become a popular trade. It still makes sense particularly for Canadian fixed income. According to Fiera Capital, our primary fixed-income sub-advisor, we could see a Bank of Canada interest rate increase by the end of 2017
  • • As a fixed income investor, you’re likely targeting a positive total return. If you’re at risk of losing more market value than you earn in yield, then it’s not a good investment tradeoff. Lower yielding short-duration ETFs can significantly reduce duration risk and help offset losses in a fixed income portfolio
  • • A key example of this is the Horizons Active Floating Rate Bond ETF (HFR). It has held up relatively well compared to the broad bond market. In fact, it has a positive three-month return of 0.80%. It currently yields 2.00%, since it invests in slightly higher yielding investment grade corporate bonds, but with a very low duration (which is 0.2 years, as at November 30, 2016). Investors could consider combining HFR with a broad-bond ETF to potentially create a yield of about 2.5%, with a duration of less than six months

Annualized Performance (%)*

ETF 1 Month 3 Months 6 Months YTD 1 Year 3 Years 5 Years Since
Inception**
Horizons Active Floating
Rate Bond ETF (HFR)
0.31 0.80 1.56 2.66 2.76 1.75 2.45 2.35

 

* As at December 15, 2016.
** Inception date of HFR is December 10, 2010.

Favour Higher Yielding Corporates Over Government Bonds

One of the key recommendations from Fiera Capital, is to consider having a heavier weighting in corporate bonds and higher yielding strategies, such as preferred shares. The rationale is simple: these yield more than government bonds and corporate credit risk (i.e. the risk of default) is at historical lows. It’s an easy way to generate extra yield. For example, the Horizons Active Corporate Bond ETF (HAB) currently yields approximately 3.4%. The ETF has lost over 1% in market value in the recent sell-off (i.e. the three-month period ending December 15, 2016), but this is not as significant as the more government-heavy broad bond strategies.

Annualized Performance (%)*

ETF 1 Month 3 Months 6 Months YTD 1 Year 3 Years 5 Years Since
Inception**
Horizons Active Corporate
Bond ETF (HAB)
-0.51 -1.32 -0.32 3.01 3.20 3.96 3.86 4.63

 

* As at December 15, 2016.
** Inception date of HAB is July 14, 2010.

  • • An even more attractive solution may be investing in Canadian Preferred Share ETFs, such as the Horizons Active Preferred Share ETF (HPR). In aggregate, this ETF is actually positively correlated to interest rates. As interest rates rise, so do rate-reset preferred shares. Preferred shares, on average, yield approximately 4.3%, providing about 100 basis points of yield spread over corporate bonds
  • • High yield bond ETFs, like the Horizons Active High Yield Bond ETF (HYI) currently provide an even bigger yield cushion. With the rally in energy prices and past default rates less than 4%, we believe the credit risk in this space remains quite low. Historically, we’ve seen that high yield bond ETFs actually do better on a total return basis during a rising interest rate environment

chart.png

 

Source: Fiera Capital as at December 31, 2015

The views/opinions expressed herein may not necessarily be the views of AlphaPro Management Inc. and/or Horizons ETFs Management (Canada) 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.

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.

Investment Objectives:
HBB: The Horizons Cdn Select Universe Bond ETF (HBB) seeks to replicate, to the extent possible, the performance of the Solactive Canadian Select Universe Bond Index (Total Return), net of expenses. The Solactive Canadian Select Universe Bond Index (Total Return) is designed to measure the performance of the Canadian investment-grade fixed income market.
HFR: The Horizons Active Floating Rate Bond ETF (HFR) seeks 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. The ETF invests in a portfolio of Canadian debt securities and hedges the portfolio’s interest rate risk to generally maintain a portfolio duration of less than two years. The ETF may use derivatives and include interest rate swaps to deliver a floating rate of income. The ETF seeks to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.
HAB: The investment objective of the Horizons Active Corporate Bond ETF (HAB) is to seek long-term moderate capital growth and generate high income. The ETF invests in a portfolio of debt securities of Canadian and U.S. companies, directly, or through investments in securities of other investment funds, including exchange traded funds. The ETF seeks to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.
HPR: The Horizons Active Preferred Share ETF (HPR) seeks to provide dividend income while preserving capital by investing primarily in preferred shares of Canadian companies. The ETF may also invest in preferred shares of companies located in the United States, fixed income securities of Canadian and U.S. issuers, including other income generating securities, as well as Canadian equity securities and exchange traded funds that issue index participation units. The ETF, to the best of its ability, seeks to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.
HYI: The Horizons Active High Yield Bond ETF (HYI) seeks to provide unitholders with: (i) high total return income; and (ii) monthly distributions. The ETF primarily invests, directly or indirectly, in high yield debt securities of North American companies. The ETF may also invest, directly or indirectly, in convertible debentures, preferred shares and mortgage-backed securities. The ETF will, to the best of its ability, seek to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.

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