March 31, 2020

For many investors, the current financial markets situation is troubling at best, particularly when it comes to corporate credit. Back in 2008 and 2009, there was palpable dread that public companies with seemingly rock-solid creditworthiness were now at risk of collapse and default. Today, we are seeing those concerns manifest once again.

A major contributor to spread and pricing issues with some of our fixed income ETFs is the widespread that corporate bonds are experiencing in the over-the-counter market. When fixed income ETFs are redeemed during a broad corporate bond sell-off, it might be difficult for market makers to find sufficient liquidity in over-the-counter market that corporate bonds trade in, since there are limited buyers in the space at that time.

These wide spreads have created a disconnect between the prices of many Canadian corporate bond ETFs, where the price returns of these ETFs are showing steep declines relative to their calculated net-asset-value (“NAV”) returns. In industry terms, we refer to this as ETFs “trading at a discount.”

A concern we are hearing from investors is whether the NAV or the price is the true reflection of the value of these bond ETFs. It would appear that the discount in the price versus the NAV does, to some degree, take into account the intra-day risk for the market makers who create and redeem units of the ETFs. Therefore, the market makers are hedging themselves against liquidity risk by offering wider bid/ask spread on these ETFs, which can also manifest itself as discount pricing on the bid price for the ETFs. However, each end-of-day NAV calculation is based on the best data available to determine the value of the underlying securities.

A key message for investors is that they should recognize that this dislocation is likely only temporary, as fiscal stimulus hopefully works its way into the system to support greater liquidity for corporate bond purchases. If corporate bond ETF unitholders sell their positions during this period of disruption, they will likely be crystalizing losses at these discounted prices, and it would likely be more advantageous if they waited to execute sell orders at prices that are more reflective of the true NAV pricing.

What About Investors Looking at the Opportunity to Enter Into Corporate Bonds?

It is clear that many institutional investors are spooked. What was widely regarded as a seemingly safe investment a month ago is now being re-evaluated on a minute-by-minute basis. During these times, there’s historically only one true risk-off asset, and that’s government-issued bonds. When a crisis hits its apex, corporate credit correlations start to move in tandem with equities.

For investors willing to look through the current level of panic, there may be a compelling investment opportunity. Some key things to consider are as follows:

1) The prompt and decisive moves by central banks to engage in monetary stimulus and quantitative easing is precisely designed to provide economic relief for companies that will see a drastic and serious decline in revenue. The cost of financing for companies has dropped dramatically, which allows them to deal with debt on their balance sheet much more efficiently.

2) These measures bring rates down close to zero, meaning, for income-focused investors of all sizes, there will be a need to find income solutions that pay a positive yield. Currently, the spreads on corporate bonds are at four year-highs but not quite at the level they were in 2008 and 2009. However, the fact that government bonds are paying nothing means that the relative yield of corporate bonds is potentially attractive. At a certain point, if, or when, we hit a stabilization point in the economic concerns around COVID-19 investment-grade corporate bonds could become particularly attractive as a source of income.

U.S. Corporate Spreads Top 300 bps!

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Source: https://www.morningstar.com/articles/973818/corporate-bonds-at-second-widest-level-in-20-years.

What Fiera Capital Thinks

The Integrated Fixed Income team at Fiera Capital, which oversees more than $20 billion in assets under management, believes the wide spread situation in corporate bonds is temporary, but will likely persist while the impact of containment of COVID-19 remains unknown. Markets don’t like uncertainty, but if there is a floor created regarding the spread of COVID-19, then the relative performance of corporate bonds vis-à-vis government bonds could be quite attractive.

Here are Fiera’s current views:

• Spreads on corporate bonds have retraced from recent tight levels and are now in a quickly widening trend. We are trending towards levels not seen since the credit widening period of early 2016 that was associated with elevated levels of economic uncertainty and a low oil price environment.

• In the last few days, Fiera Capital has again started to participate in credit markets more actively as they now finally see some attractive opportunities starting to appear.

• Fiera Capital expect spreads to continue to be soft and to continue to reprice as the market continues to see the number of COVID-19 infections outside China increase with little signs of containment. Meanwhile, they expect looser monetary policy and fiscal stimulus to somewhat limit the downside (e.g. coordinated action by G7 countries to limit downside in financial markets). As Fiera Capital expects the market to receive more positive news in the later part of Q2 2020, they expect more stability to arise in credit markets. The sectors Fiera Capital is most cautious about include the energy sector, Canadian subordinated banks, autos, airports and REITs. Fiera Capital is continuing to do a thorough review of these sectors to account for the impact of the virus and – more recently – the fallout from the drop in oil prices.

• Fiera Capital’s approach will be, as always, to use a moderate and disciplined approach to taking advantage of opportunities in increasing their investment yield by considering adding sound and compensated credit risk exposure. While they are currently evaluating entry points to add credit, Fiera Capital is also examining further reduction in more sensitive issuers and sectors of their portfolios. Their current strategy remains to focus their corporate bond exposures to below five-year with some enhanced focus on tactical trading opportunities.

One ETF strategy that may be particularly well-positioned for a recovery is the Horizons Ultra-Short Term Investment Grade Bond ETF (HFR). The portfolio yield on this ETF after the most recent sell-off is now above 3.6%. This may not seem high compared to other income strategies at this point in time, but consider that HFR only invests in high investment-grade bonds with an Aaverage credit quality, and has virtually no duration risk since it is mandated to maintain a duration of less than one year.

While government bonds hurtle towards zero, and high interest savings rates are around 1.00% to 1.25%, investors are getting compensated with a spread of more than 200 basis points (“bps”) to own high-quality, Canadian corporate bonds.

These types of opportunities don’t present themselves very often, and if an investor is looking for a defensive strategy with some upside if credit spreads tighten, they could potentially generate an attractive yield with HFR. Investors could consider using HFR in the following ways:

1) Placeholder for conservative fixed income with longer-term time horizons. If an investor feels that long term, the current economic crisis surrounding COVID-19 will pass, HFR may give them a yield from here on out that is likely in excess of 300 bps at its current entry point, whereas the yield on most other fixed income and savings vehicles could decline.

2) Reduce credit risk on riskier holdings. HFR is now yielding what senior loans yielded roughly a year ago, but with a much higher credit profile. Investors could consider selling senior loan strategies and harvest a capital loss, and then move into HFR with what is likely a higher credit profile and likely the same level of income.

Active management can potentially add value

There is additional potential value to actively managed strategies in these markets:

1) Independent credit analysis: Fiera Capital is able to upgrade their portfolio and determine credit risk independently of credit rating agencies. This type of market allows them to really improve the credit quality of the portfolio and find some great value.

2) Not forced to buy or sell issuances: Fiera Capital can be selective in what they choose to add to or remove from the portfolio upon subscription or redemption, or in managing the portfolio generally, as opposed to being bound to certain issues as with an index ETF.

Pricing issues and volatility in the market may continue for the foreseeable future, but, in the long term, HFR, and the broader corporate fixed income strategy including the Horizons Active Corporate Bond ETF (HAB), may offer a compelling way to deploy fixed income assets. Given the level of fiscal and monetary stimulus in the market, corporate balance sheets are expected to have a decent chance of weathering this storm, which means there is a reasonable expectation of a rebound in their credit risk assessment and an improvement in valuations.

Performance of HFR

  1 month
(%)
3 month
(%)
6 month
(%)
YTD
(%)
1 year
(%)
3 year
(%)
5 year
(%)
Since
Inception (%)
HFR -4.23% -3.84% -2.85% -3.84% -1.34% 0.84% 1.20% 1.92%
 

Source: Bloomberg as at March 31, 2020.
Inception Date: December 10, 2010
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 ETFs or returns on investment in the ETFs.

Commissions, management fees and expenses all may be associated with an investment in exchange traded products (the "Horizons Exchange Traded Products") managed by Horizons ETFs Management (Canada) Inc. The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the relevant prospectus before investing.

Certain statements may constitute a forward looking statement, including those identified by the expressions “anticipate”, “estimate” or “expect” and similar expressions (including grammatical variations thereof) to the extent they relate to the ETFs or Horizons ETFs. The forward-looking statements are not historical facts but reflect the ETFs, the ETF’s managers or Horizons ETFs 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 the ETFs’ forward looking statements. These forward-looking statements are made as of the date hereof and the ETFs 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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Commissions, management fees and expenses all may be associated with an investment in exchange traded products managed by Horizons ETFs Management (Canada) Inc. (the "Horizons Exchange Traded Products"). The Horizons Exchange Traded Products are not guaranteed, their values change frequently and past performance may not be repeated. The prospectus contains important detailed information about the Horizons Exchange Traded Products. Please read the relevant prospectus before investing.

The Horizons Exchange Traded Products include our BetaPro products (the “BetaPro Products”). The BetaPro Products are alternative mutual funds within the meaning of National Instrument 81-102 Investment Funds, and are permitted to use strategies generally prohibited by conventional mutual funds: the ability to invest more than 10% of their net asset value in securities of a single issuer, to employ leverage, and engage in short selling to a greater extent than is permitted in conventional mutual funds. While these strategies will only be used in accordance with the investment objectives and strategies of the BetaPro Products, during certain market conditions they may accelerate the risk that an investment in shares of a BetaPro Product decreases in value. The BetaPro Products consist of our 2x Daily Bull and 2x Daily Bear ETFs (“2x Daily ETFs”), Inverse ETFs (“Inverse ETFs”) and our BetaPro S&P 500 VIX Short-Term Futures™ ETF (the “VIX ETF”). Included in the 2x Daily ETFs and the Inverse ETFs are the BetaPro Marijuana Companies 2x Daily Bull ETF (“HMJU”) and BetaPro Marijuana Companies Inverse ETF (“HMJI”), which track the North American MOC Marijuana Index (NTR) and North American MOC Marijuana Index (TR), respectively. The 2x Daily ETFs and certain other BetaPro Products use leveraged investment techniques that can magnify gains and losses and may result in greater volatility of returns. These BetaPro Products are subject to leverage risk and may be subject to aggressive investment risk and price volatility risk, among other risks, which are described in their respective prospectuses. Each 2x Daily ETF seeks a return, before fees and expenses, that is either 200% or –200% of the performance of a specified underlying index, commodity futures index or benchmark (the “Target”) for a single day. Each Inverse ETF seeks a return that is –100% of the performance of its Target. Due to the compounding of daily returns a 2x Daily ETF’s or Inverse ETF’s returns over periods other than one day will likely differ in amount and, particularly in the case of the 2x Daily ETFs, possibly direction from the performance of their respective Target(s) for the same period. Hedging costs charged to BetaPro Products reduce the value of the forward price payable to that ETF. Due to the high cost of borrowing the securities of marijuana companies in particular, the hedging costs charged to HMJI are expected to be material and are expected to materially reduce the returns of HMJI to unitholders and materially impair the ability of HMJI to meet its investment objectives. Currently, the manager expects the hedging costs to be charged to HMJI and borne by unitholders will be between 10.00% and 45.00% per annum of the aggregate notional exposure of HMJI’s forward documents. The hedging costs may increase above this range. The manager will publish, on its website, the updated monthly fixed hedging cost for HMJI for the upcoming month as negotiated with the counterparty to the forward documents, based on the then current market conditions. The VIX ETF, which is a 1x ETF, as described in the prospectus, is a speculative investment tool that is not a conventional investment. The VIX ETF’s Target is highly volatile. As a result, the VIX ETF is not intended as a stand-alone long-term investment. Historically, the VIX ETF’s Target has tended to revert to a historical mean. As a result, the performance of the VIX ETF’s Target is expected to be negative over the longer term and neither the VIX ETF nor its target is expected to have positive long-term performance. Investors should monitor their holdings in BetaPro Products and their performance at least as frequently as daily to ensure such investment(s) remain consistent with their investment strategies.

*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.