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Since the beginning of the COVID-19 pandemic the fixed income asset class has not been as attractive to investors, as evidenced by lower historical returns throughout the period and in-flows, compared to stimulus-driven equity market gains.

However, the recent stock market downturn could shift investor interest back towards the fixed income market in an effort to preserve capital while weathering this latest bout of market volatility.

Yet, with looming rate hikes also signalled by the U.S. Federal Reserve, the Bank of Canada and other central banks across the world, there could be more frustration ahead; particularly for fixed income investors with long-term bond exposure.

For investors seeking a potentially greater risk/reward trade-off as part of their fixed income approach in 2022, the Horizons Active Ultra-Short Term Investment Grade Bond ETF (HFR) might be worth a consideration.

As an ETF, HFR is effectively neutral on rate increases and could see its yield rise without the impending pain of capital losses that other long-term bond ETFs could suffer. Consequently, the Horizons Cash Maximizer ETF (HSAV) and the Horizons High Interest Savings ETF (CASH) could also benefit from potential rate hikes but at a much lower yield threshold, compared to HFR.

In the blog below, we’ve sought to describe some of the key reasons why short-term duration bond ETFs like HFR can offer better protection. We’ve also included a number of comparisons to other Canadian-listed fixed income ETFs with longer durations or lower yields which may be more impacted by a deluge of policy rate hikes in 2022.

Risk and Return: Is Your Duration Short-Enough?

There is a general consensus among many fixed income analysts that interest rates should rise in 2022, barring any significant surprises that could derail inflationary pressures in the wider global economy. The response for some investors has been to move their fixed income allocation into lower-duration ETFs, which on average hold shorter maturity terms in their portfolios.

Increasingly, this is becoming a very crowded fixed income trade, and the potential risk/reward profile of going short on duration may not be that beneficial. In most cases, owning bonds with durations between two and three years is, currently, a potentially poor risk/reward trade off. This is because the yield relative to the current interest rate risk isn’t much different than owning higher duration bonds.

Let’s take a look at the current interest rate curve on Canadian bonds. It shows a clear picture of the challenge that investors are facing when determining “How short is short enough?” to generate protection against rising interest rates.

Generally, the potential risk-reward trade-off on longer duration bonds can be relatively poor. Standard duration math suggests that for every year of duration for a fixed income security, an investor can typically anticipate the loss of 1% of capital for every 1% rise in interest rates.

In this case, investors are only being compensated about an additional 20 basis points (bps) to own a two-year bond versus a one-year bond. Even on one-year bonds, investors could still expect to see a capital loss if rates moved more than 1%. Duration management has arguably never been so important in a market where interest rates are rising precipitously.

The chart below compares the Canadian government yield as at December 31, 2020 and December 31, 2021.

rate-compare.png

Source: Bloomberg as at December 31, 2021

This potentially poorer risk/reward trade-off has forced many investors to move to the ultra-short end of the curve, and while six-month rates started 2022 at around 0.40%, they are now hovering around 0.60% in anticipation of drastic rate increases (Source: Bloomberg as at January 21, 2022).

Many major Canadian banks have raised interest rate targets for 2022: Scotiabank has a target in excess of a 1.25%1 rise in the overnight rate in 2022, TD Bank has a forecast of 1.25%2 and RBC has a 1.00%3 target.

Horizons ETFs’ key fixed income sub-advisor, Fiera Capital, has a target of between 1.00% and 1.75%, depending on the amplitude of inflation. Based on current yields, we would anticipate that any fixed income strategy with a duration greater than two years would likely continue to face performance challenges unless they moved farther out on the credit curve – that is, moving more into BBB or below rated bonds.

In the higher quality investment grade space, it will likely be very difficult to navigate this rate environment.

Being ultra-short duration (bond or fixed income strategies with less than a year) has been one of the most reliable ways to ensure that a fixed income portfolio can generate positive returns.

This chart shows investors that the difference between a one- and two-year bond, at the end of 2021, was only 20 bps. Just as startling, the difference between a five- and 10-year bond was almost the same. 10-year bonds are effectively compensating investors the same as five-year bonds, despite having double the duration risk, with the same being true for one- and two-year bonds.

yield-dif.png

Source: Bloomberg, as at December 31, 2021

Investors could look at these two charts and possibly surmise that the best way to deal with the rising rates is to hold ultra-short duration bonds. The challenge is that despite yields rising, this is still a very low yield part of the curve.

Most fixed income ETFs that have less than a year in duration are likely to yield less than 1%, whereas ETFs in the two-to-three-year range should have slightly higher yields but have been negatively impacted by duration.

One ETF strategy that has held up extraordinarily well in this environment is the Horizons Active Ultra-Short Term Investment Grade Bond ETF (HFR), which was one of the best performing ETFs in its category in 2021 (according to Morningstar Direct)4 with a 0.83% return vs. a median -1.01% return for the short-term fixed income category.

What makes HFR so well structured for this market environment is that it’s able to provide ultra-short duration exposure while maintaining a higher yield due to its ability to harvest an attractive corporate bond premium from its underlying holdings.

HFR will typically own a portfolio of higher investment grade mid-duration Canadian corporate bonds. The ETF will eliminate the majority of the interest rate risk of owning these bonds by entering into a fixed-for-floating interest rate swap. The ETF will pay a fixed rate in exchange for receiving the Canadian Dealer Offered Rate (CDOR). As at January 21, 2022 the three-month CDOR rate is around 0.75%.

Current Key Details on HFR

1) HFR is a high investment-grade corporate bond strategy (average credit rating of BBB+)
2) HFR reduces the interest rate risk (duration) of the portfolio 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 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 drops, the opposite is expected to happen with the yield of these ETFs ultimately declining
4) HFR has a current yield5 of approximately 1.47%. The excess yield from HFR is generated from the spread of the corporate bonds it holds above the fixed rate the ETF pays

If we look at three key factors, HFR offers a strong risk reward trade-off by offering an attractive combination of yield, credit quality and low duration.

According to Morningstar, the average yield to maturity in the short-term fixed income category is 1.31% with an average duration of 2.5 years. In order to effectively generate a positive return in 2022, a short-term fixed income ETF will likely need to have a yield to maturity that exceeds its duration, if rates move between 0.75% and 1.25% in 2022. ETF mandates with a higher duration than yield would be expected to lose about 1% for every year of duration which means they could suffer total return losses in the portfolio in 2022.

Below shows HFR’s key metrics and where it should be well positioned for a rising interest rate environment while also maintaining an investment grade rating.

Horizons Active Ultra-Short Term Investment Grade Bond ETF (HFR) Key Metrics

Fund Size
(Millions)
Management Fee
(plus applicable
sales tax)
Current
Yield
Yield To
Maturity
Duration Avg. Credit
Quality 
542, 891 0.40 1.47 1.23 0.7 BBB+
 

Source: Morningstar as at December 31, 2021

2021 Performance

Below is a selected group of competitors in the Canadian Short-Term Fixed Income category that have been selected based on relatively high assets under management. In 2021, HFR outperformed amongst this group of competitors on a one year basis.

ETF Ticker 1 Mo
(%)
3 Mo 
(%)
6 Mo 
(%)
YTD 
(%)
1 Yr 
(%)
Annlzd
3 Yr 

(%)
Annlzd
5 Yr 

(%)
Since
Inception 

(%)
Inception
Date
Horizons Active
Ultra-Short Term
Investment Grade
Bond ETF
HFR 0.29 0.07 0.32 0.83 0.83 2.83 2.35 2.36 2010-12-10
BMO Ultra Short-
Term Bond ETF
ZST 0.05 0.03 0.08 0.23 0.23 1.47 1.56 1.67 2011-01-28
Fidelity Canadian
Short Term Corp
Bond ETF
FCSB 0.21 -0.41 -0.27 -0.51 -0.51 N/A N/A 2.79 2019-09-20
iShares Core
Canadian ST
Corp Bond ETF
XSH 0.45 -0.46 -0.26 -0.62 -0.62 3.34 2.52 2.67 2011-09-13
BMO Short
Corporate
Bond ETF
ZCS 0.44 -0.45 -0.27 -0.62 -0.62 3.29 2.47 2.89 2009-10-20
Manulife Smart
Short-Term
Bond ETF
TERM 0.39 -0.48 -0.32 -0.64 -0.64 N/A N/A -0.15 2020-11-25
Mackenzie
Canadian Short-
Term Bond ETF
QSB 0.35 -0.48 -0.41 -0.71 -0.71 2.18 N/A 2.15 2018-01-29
Vanguard Canadian
Short-Term
Bond ETF
VSB 0.33 -0.59 -0.48 -1.03 -1.03 2.29 1.73 1.82 2011-11-30
iShares Core
Canadian Short-
Term Bond ETF
XSB 0.37 -0.52 -0.47 -1.04 -1.04 2.36 1.76 3.69 2000-11-20
 

Source: Morningstar and ETF provider websites as at December 31, 2021.

HFR’s primary risk versus these competitors is its reliance on corporate credit, but we view this as a net benefit more than a detractor for this ETF in 2022.

The reason this trade makes sense right now is there is not a lot of analyst concern about corporate defaults, so while these spreads are low by historical standards, they can remain in this range for quite a long time – keep in mind we’re likely in the midst of a rising interest rate environment. Earnings remain strong for corporate earning and default risk is relatively low. Investors can use this to their potential advantage with a strategy like HFR that can generate a higher net yield on short-duration versus government strategies.

As a result, the risk of interest rates rising probably supersedes corporate default risk at this point in the credit cycle.

In this blog, we’ve sought to describe some of the key reasons why short-term duration bond ETFs, like HFR, can offer better protection versus longer duration bond ETFs. Perhaps you’re looking to weather equity market volatility or just looking to reallocate your fixed income exposure for 2022. Whatever your reason, by using HFR, you could potentially benefit from the higher yield from corporate credit while reducing interest rate risk.

1https://www.scotiabank.com/ca/en/about/economics/economics-publications/post.other-publications.foreign-exchange.foreign-exchange-outlook--december-16--2021-.html#:~:text=The%20Bank%20of%20Canada's%20overnight,January%20is%20an%20underpriced%20risk
2https://economics.td.com/ca-quarterly-economic-forecast
3http://www.rbc.com/economics/economic-reports/pdf/financial-markets/rates.pdf
4https://www.morningstar.com/etfs/xtse/hfr/performance
5As at December 31, 2021

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.

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.

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.

© 2022 Morningstar. All Rights Reserved. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information. Past performance is no guarantee of future results.

The Horizons Cash Maximizer ETF (“HSAV”) uses cash accounts and does not track a traditional benchmark but rather a compounding rate of interest paid on a cash deposit that can change over time. Any distributions which are received by HSAV are reflected automatically in the net asset value (NAV) of HSAV. As a result, the shareholders of HSAV are not expected to receive any taxable distributions

If HSAV/HSUV.U experience a significant increase in total NAV, the Manager may, at its sole discretion and if determined to be in the best interests of shareholders, decide to suspend subscriptions for new ETF shares of either ETF if considered necessary or desirable in order to manage potential tax implications and/or to permit the ETF(s) to achieve, or continue to achieve, its(their) investment objective(s). During a period of suspended subscriptions, if any, investors should note that ETF shares of HSAV/HSUV.U would be expected to trade at a premium or substantial premium to the NAV per ETF Share of HSAV/HSUV.U. During such periods, investors are strongly discouraged from purchasing ETF shares of HSAV/HSUV.U on a stock exchange. Any suspension of subscriptions or resumption of subscriptions will be announced by press release and announced on the Manager’s website. A suspension of subscriptions, if any, will not affect the ability of existing Shareholders to sell their ETF Shares in the secondary market at a price reflective, or potentially higher than, the NAV per ETF Share.

HFR - The investment objective of the ETF is 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 one year. Horizons HFR may also invest in debt securities of U.S. companies, directly, or through investments in securities of other investment funds, including exchange-traded funds. Horizons HFR uses derivatives, including interest rate swaps, to deliver a floating rate of income. Horizons HFR, to the best of its ability, seeks to hedge its non-Canadian dollar currency exposure to the Canadian dollar at all times.

XSH - The ETF seeks to provide income by replicating, to the extent possible, the performance of the FTSE Canada Universe + Maple Short Term Corporate Bond Index, net of expenses. Under normal market conditions, XSH will primarily invest in Canadian fixed income securities.

ZCS - The ETF tracks the FTSE Canada Short Corporate Bond Index, which includes investment-grade corporate bonds denominated in Canadian dollars with between one and five years remaining until maturity. Qualifying issues must be fixed-rate and have at least $100 million in outstanding face value. The index is market-value-weighted.

ZST - The ETF seeks to provide exposure to a variety of fixed income securities with a remaining effective term to maturity of one year or less. The ETF will primarily invest in money market instruments and directly in fixed income securities, including corporate, Government of Canada, provincial and municipal bonds. The ETF may invest in floating rate instruments, floating rate preferred shares and other floating rate securities, subject to the rate reset date being no greater than one year and the term being no greater than five years.

FCSB - The ETF aims to provide a steady flow of income. It invests primarily in Canadian fixed income securities, usually with an average term to maturity of five years or less. It can invest in these securities either directly or indirectly through investments in underlying investment funds.

QSB - The ETF seeks to replicate, to the extent reasonably possible and before fees and expenses, the performance of the Solactive Canadian Select Short-Term Bond Index, or any successor thereto. It invests primarily in Canadian investment grade bonds.

TERM - The ETF seeks to earn the highest level of income consistent with the preservation of capital by investing primarily in a diversified portfolio of short-term fixed income securities issued by Canadian corporations and may also invest in short-term fixed income securities issued by federal, provincial or municipal governments in Canada. In order to achieve its investment objectives, the fund invests mainly in short-term Canadian corporate investment-grade fixed income securities.

VSB - The ETF seeks to track, to the extent reasonably possible and before fees and expenses, the performance of a broad Canadian bond index with a short-term dollar-weighted average maturity. Currently, this Vanguard ETF seeks to track the Bloomberg Global Aggregate Canadian Government/Credit 1–5 year Float Adjusted Bond Index (or any successor thereto). It invests primarily in public, investment-grade fixed income securities issued in Canada.

XSB – The ETF seeks to provide income by replicating the performance of the FTSE Canada Short Term Overall Bond Index™, net of expenses.

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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 value changes frequently and past performance may not be repeated. Certain ETFs may have exposure to leveraged investment techniques that magnify gains and losses and which may result in greater volatility in value and could be subject to aggressive investment risk and price volatility risk. Such risks are described in the prospectus. The prospectus contains important detailed information about the ETF. 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 Daily Bull and Daily Bear ETFs (“Leveraged and Inverse Leveraged ETFs”), Inverse ETFs (“Inverse ETFs”) and our BetaPro S&P 500 VIX Short-Term Futures™ ETF (the “VIX ETF”). Included in the Leveraged and Inverse Leveraged 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 Leveraged and Inverse Leveraged 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 Leveraged and Inverse Leveraged ETF seeks a return, before fees and expenses, that is either up to, or equal to, 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 Leveraged and Inverse Leveraged 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 Leveraged and Inverse Leveraged ETFs, possibly direction from the performance of their respective Target(s) for the same period. For certain Leveraged and Inverse Leveraged ETFs that seek up to 200% or up to or -200% leveraged exposure, the Manager anticipates, under normal market conditions, managing the leverage ratio as close to two times (200%) as practicable however, the Manager may, at its sole discretion, change the leverage ratio based on its assessment of the current market conditions and negotiations with the respective ETF’s counterparties at that time. 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 publishes 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. BetaPro Bitcoin ETF (“HBIT”), and BetaPro Inverse Bitcoin ETF (“BITI”), which are a 1X ETF, and an up to -1X ETF, respectively, as described in the prospectus, are speculative investment tools that are not conventional investments. Their Target, an index which replicates exposure to rolling Bitcoin Futures and not the spot price of Bitcoin, is highly volatile. As a result, neither ETF is intended as a stand-alone investment. There are inherent risks associated with products linked to crypto-assets, including Bitcoin Futures. While Bitcoin Futures are traded on a regulated exchange and cleared by regulated central counterparties, direct or indirect exposure to the high level of risk of Bitcoin Futures will not be suitable for all types of investors. An investment in any of the BetaPro Products is not intended as a complete investment program and is appropriate only for investors who have the capacity to absorb a loss of some or all of their investment. Please read the full risk disclosure in the prospectus before investing. 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.

Horizons Total Return Index ETFs (“Horizons TRI ETFs”) are generally index-tracking ETFs that use an innovative investment structure known as a Total Return Swap to deliver index returns in a low-cost and tax-efficient manner. Unlike a physical replication ETF that typically purchases the securities found in the relevant index in the same proportions as the index, most Horizons TRI ETFs use a synthetic structure that never buys the securities of an index directly. Instead, the ETF receives the total return of the index through entering into a Total Return Swap agreement with one or more counterparties, typically large financial institutions, which will provide the ETF with the total return of the index in exchange for the interest earned on the cash held by the ETF. Any distributions which are paid by the index constituents are reflected automatically in the net asset value (NAV) of the ETF. As a result, the Horizons TRI ETF receives the total return of the index (before fees), which is reflected in the ETF’s share price, and investors are not expected to receive any taxable distributions. Certain Horizons TRI ETFs (Horizons Nasdaq-100 ® Index ETF and Horizons US Large Cap Index ETF) use physical replication instead of a total return swap. The Horizons Cash Maximizer ETF and Horizons USD Cash Maximizer ETF use cash accounts and do not track an index but rather a compounding rate of interest paid on the cash deposits that can change over time.

*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.