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The Discounted Lunch: Using HFR to Reduce Duration

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BY MARK NOBLE, SENIOR VICE-PRESIDENT, ETF STRATEGY, HORIZONS ETFS

March 27, 2018

There’s no free-lunch when it comes to investing. Every investment has a risk/reward trade-off; generating returns from one area typically necessitates taking on risk or missing out on returns somewhere else. The Horizons Active Floating Rate Bond ETF (HFR) is not a free lunch in fixed income investing, but may be the closest thing you get to a discounted one in today’s market!

Here are the current, key details for HFR:

1) It’s a high investment-grade corporate bond strategy (average credit rating of A).
2) The ETF currently reduces the interest rate risk (duration) of the portfolio to near zero 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 the 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 HFR ultimately declining.
4) As interest rates have risen, so too has the yield of HFR. HFR has a current yield* of approximately 2.28% and a trailing 12-month yield** of 2.15%. To give some context, the yield** on the broad Canadian bond universe (as represented by the FTSE/TMX All-Canada Bond Index) is approximately 3%.

This is likely the narrowest yield spread in ETF history between HFR and ETFs that track the FTSE/TMX All-Canada Bond Index, such as the BMO Aggregate Bond Index ETF (ZAG) and the iShares Core Canadian Universe Bond Index ETF (XBB). On the flip side, the duration difference between HFR and these broad-bond ETFs is significant. ZAG’s duration, for example, is more than seven years (as at February 28, 2018)! That means if interest rates rise more than 50 basis points over the next year – Fiera Capital is predicting at least two more rate hikes from the Bank of Canada in 2018 – ZAG could be expected to lose approximately 3.5%.

We see the comparative risk/reward trade-off of HFR as superior to that of its competitor investment-grade bond ETFs. For a 61 basis point difference in yield (current yield* of ZAG, less current yield* of HFR), you can significantly mitigate the interest rate risk of a portfolio.

Scaling-In

While a compelling case could be made to sell full portions of incumbent high-duration ETFs like ZAG and buy HFR, the practicality of doing so may be difficult. However, there is an easy way to use HFR to reduce the overall portfolio risk of interest-rate sensitive fixed income portfolios: An investor could scale-in HFR.

Here’s how: Take some percentage of a fixed income portfolio and allocate it to HFR. By doing this, investors can reduce their interest-rate risk without having to fully sell-out current positions on their portfolios.

We’ve built some handy tables you can use to see how HFR could reduce the duration of a portfolio when combined with comparable ETFs. You can also see what the approximate combined duration and yield of this strategy would be.

For example, if you were to combine a 50/50 allocation of HFR and ZAG, you would have a combined yield* of approximately 2.58% and a duration of approximately 4.15 years.

HFR ZAG Duration Yield* HFR XBB Duration Yield*
0% 100% 7.36 2.89 0% 100% 7.37 2.91
10% 90% 6.72 2.83 10% 90% 6.73 2.85
20% 80% 6.08 2.77 20% 80% 6.08 2.78
30% 70% 5.43 2.71 30% 70% 5.44 2.72
40% 60% 4.79 2.65 40% 60% 4.8 2.66
50% 50% 4.15 2.58 50% 50% 4.16 2.59
60% 40% 3.51 2.52 60% 40% 3.51 2.53
70% 30% 2.87 2.46 70% 30% 2.87 2.47
80% 20% 2.22 2.4 80% 20% 2.23 2.41
90% 10% 1.58 2.34 90% 10% 1.58 2.34
100% 0% 0.94 2.28 100% 0% 0.94 2.28

 

Source: Bloomberg as at March 23, 2018.

You don’t have to limit using HFR to index strategies. Consider for example, the Pimco Monthly Income ETF (PMIF). This is an ETF class unit of one of the largest mutual funds in Canada, with about $16.4 billion in assets under management.

It’s interesting to note that the management team of this fund has brought down the duration of the strategy to about 3.4 years (Bloomberg, as at March 23, 2018) – but this also means the yield* has come down to about 5.52%. Compare this to HFR, which is yielding* about 2.28% with a duration of close to zero. Again, why not scale-in HFR? In this case, an investor could take a 30% position in HFR and a 70% in PMIF, to create a low-duration strategy of approximately 2.70 years with a yield* of approximately 4.55%.

HFR PMIF Duration Yield*
0% 100% 3.43 5.52
10% 90% 3.18 5.19
20% 80% 2.93 4.87
30% 70% 2.68 4.55
40% 60% 2.43 4.22
50% 50% 2.19 3.9
60% 40% 1.94 3.57
70% 30% 1.69 3.25
80% 20% 1.44 2.93
90% 10% 1.19 2.6
100% 0% 0.94 2.28

 

Source: Bloomberg, as at March 23, 2018.

Hidden Carbs

Keeping with this lunch theme of HFR being a discounted lunch – there are some hidden carbs (risks) to be aware of, so to speak. They come from its reliance on corporate credit to generate its excess yield vs. government bonds and cash instruments. Credit spreads are quite tight from a historical perspective, meaning that there is probably a greater likelihood of spreads widening rather than coming in on a go-forward basis. This could negatively impact the yield of HFR.

This Bloomberg chart below shows that there’s really only about 100 basis points of spread between investment-grade corporate bonds and government bonds on the short end of the curve. This remains a key risk.

Bloomberg Chart

 

Source: Bloomberg, March 9, 2018.

The reason this trade may make sense right now is that there is not a lot of concern regarding corporate defaults, so while these spreads are low by historical standards, they can potentially remain in this range for quite a long time – keep in mind that many believe we’re likely in the midst of a rising interest rate environment.

As result, we believe that the risk of interest rates rising probably supersedes corporate default risk at this point in the credit cycle. By using HFR, investors can potentially benefit from the higher yield from corporate credit while reducing overall interest rate risk.

* An estimate of the annualized yield an investor would receive if the most recent distribution rate remained the same for the next 12 months, stated as a percentage of the net asset value per unit on March 23, 2018.

** The yield an investor would have received if they had held the ETF over the last 12 months, stated as a percentage of the net asset value per unit on the last business day of the most recent month end.

Investment Objectives:

XBB: Seeks to provide income by replicating the performance of the FTSE TMX Canada Universe Bond Index™, net of expenses.
ZAG: Seeks to replicate, to the extent possible, the performance of the FTSE TMX Canada UniverseXM Bond Index™, net of expenses. The Fund invests in a variety of debt securities primarily with a term to maturity greater than one year.
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. 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 two years.
PMIF: Seeks maximum current income consistent with preservation of capital and prudent investment management.

Annualized Performance1

 ETF 1-mo 3-mo 6-mo YTD 1-yr 3-yr 5-yr Since Inception
 ZAG 0.13% -1.11% -0.10% -0.69% 0.80% 0.65% 2.57% 3.76%2
 HFR 0.01% 0.44% 1.13% 0.34% 1.91% 1.76% 1.90% 2.36%3
 XBB 0.14% -1.09% -0.05% -0.69% 0.87% 0.58% 2.53% 5.12%4

 

1 As at February 28, 2018.
2 Performance since inception on January 19, 2010.
3 Performance since inception on December 10, 2010.
4 Performance since inception on November 20, 2000.

The indicated rates of return are the historical annual compounded total returns including changes in per unit value and reinvestment of all dividends or 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 in the table are not intended to reflect future values of the ETF or returns on investment in the ETF. Only the returns for periods of one year or greater are annualized returns.

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.

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.

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