In a declining interest rate environment like the one we’ve observed over the last 12 months, it can be tempting to move investments into ultra-defensive income strategies—most notably, cash.
In Canada, we’ve seen approximately $2 billion go into High-Interest Savings Account ETFs this year, according to National Bank (as at December 1, 2019). These ETFs have certain liquidity and safety advantages compared to GICs, but when we factor in core inflation as measured by the Consumer Price Index-trim measure (CPI trim) — which filters out extreme price movements potentially caused by factors specific to certain components — most cash or cash-equivalent rates fall short of generating a positive real rate of return. After adjusting for inflation, these ETFs often generate a negative real return.
As you can see, most major developed markets have moved back towards ultra-low or even negative interest rates over the last year.
Federal Overnight Rates
Source Bloomberg from November 30, 2014 to November 30, 2019.
This means the only real reason to hold cash is for portfolio risk protection. An investor who opts to hold cash has either:
a) A short-term or immediate need for cash to purchase something
b) An assumption of a negative real-rate of return
A Cash Alternative to Consider
For investors looking to generate a real rate of return in the traditional cash-allocation or conservative portion of their portfolio, there is the Horizons Active Floating Rate Bond ETF (HFR) and the Horizons Active US Floating Rate Bond (USD) ETF (HUF.U) for U.S. dollar accounts.
Here’s how HFR and HUF.U work:
1) They are high investment-grade corporate bond strategies (average credit rating of A- for HFR and BBB+ for HUF.U).
2) These ETFs currently hedge the interest rate risk to maintain portfolio duration of less than two years through interest rate swaps on the underlying portfolio of bonds. This swap earns the Canadian Dealer Offer Rate (CDOR) for HFR and the London Interbank Offered Rate (LIBOR) for HUF.U.
3) As the CDOR or LIBOR 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 or LIBOR drops, the opposite is expected to happen, with the yield of these ETFs ultimately declining.
4) According to Bloomberg, as at November 30, 2019, HFR had a trailing 12-month yield of approximately 2.57%, and HUF.U had a trailing 12 month yield of 3.98%.
These yield metrics are important because they are slightly above the core inflation rate, which is currently around 2%. In the graph below, we’ve plotted HFR and the Purpose High Interest Saving ETFs (PSA) to demonstrate that HFR’s return has generally been above inflation, a benefit of its floating yield structure. Meanwhile, PSA holders have generally seen a negative real rate of return after core inflation is factored in.
Over the five-year period from November 30, 2014 to November 30, 2019, the trailing 12-month yield of PSA only exceeded core inflation in four months, averaging 1.31%, with an average trailing 12-month real yield of -50 bps. On the other hand, HFR’s trailing 12-month yield only dipped below core inflation three times, averaging 2.18% with an average trailing 12-month real yield of 37 bps over the same period.
Source: Bloomberg as at November 30, 2019
Taking Advantage of Corporate Credit
One of the advantages of owning corporate credit is that a declining interest rate environment is generally favourable for corporate credit. The cost of debt-funding for corporations decreases as interest rates do, so the spread on corporate bonds tends to be historically tighter during periods of interest rate contraction.
Right now, there is a potential upside in owning high-investment grade corporate debt compared to short-term government debt or basic cash, since there is not a lot of concern regarding corporate defaults. While spreads of high-investment grade corporate debt are low by historical standards, they can potentially remain in this range (or tighten even further) for quite a long time.
As a result, we believe that the risk of negative real rate of return probably supersedes corporate default risk at this point in the credit cycle. By using HFR or HUF.U, investors can potentially benefit from the higher yield from corporate credit. At the same time, they can reduce overall interest rate risk and generate a yield for their conservative fixed income allocation that can generates returns keeping pace with inflation.
More info on HFR, HUF.U and PSA:
Source: Bloomberg as at November 30, 2019
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 above are not indicative of future returns. The ETFs are not guaranteed, their values change frequently, and past performance may not be repeated.
The views/opinions expressed herein may not necessarily be the views of 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.