You have to have a bit of sympathy for savers and income-focused investors — it’s really not a great time to be an income investor given the current high level of risk relative to historically low yields in fixed income strategies.

One of the cruel twists of math with fixed income investing is that declining yields technically increase the risk of investing in fixed income. Even if the credit risk of a certain type of bond (i.e., its default risk) hasn’t changed, the risk of owning the bond has increased with lower yields, since there is less of an income offset if interest rates decline or there is a sell-off in credit.

Here’s a look at the credit risk of owning high yield bonds vs. investment-grade bonds as measured by their credit spreads – that is, the excess yield they generate versus government bonds:


Source: Bloomberg, as at December 31, 2020.

These yields are extremely low on a historical basis, and could potentially leave investors subject to significant pricing risk if interest rates rise. We’ve seen some of this already, with interest rates rising during the latter end of February 2021, and the Canadian five-year bonds, for example, rising from 0.40% to approximately 0.90% during that same month.

Bond holders see the impact for every 1% rise in interest rates; in these cases, we would expect a 1% decline in the price value of the bond for every year until it matures, which is referred to as its duration. On a five-year Canadian government bond, we would expect then that the bond could lose 0.50% for every year of duration, in response to a 0.50% move upwards on interest rates. That means we anticipate that holders of those bonds lost more than 2.00% alone during the month of February 2021.

Understanding ETF Yields

Adding further confusion for investors is the fact that there is a significant gap between the current yields being reported by many ETFs (that is, the yield based on most recent distributions) versus the yield being generated by the portfolio on a go-forward basis, which is typically referred to as the yield-to-maturity.

The Current Yield for an ETF is based on the most recent distribution by the ETF and the expected annual income that would be generated by the ETF (interest or dividends) after a full year at that distribution level, divided by the current price of the security at the close of the day prior to the ex-dividend date of the last distribution. If an ETF doesn’t reduce its monthly or quarterly distributions or pays a fixed amount, the current yield can potentially be higher than what would be expected to be earned on a go-forward basis. Also, if higher income was generated from previously higher coupon payments in the portfolio, that could also mean the current yield being generated is higher than what is going to be earned going forward.

Investors can look at the yield to maturity to potentially gauge the potential yield going forward on an ETF. Yield-to-maturity (YTM) is the total return anticipated on a bond if the bond is held until its maturity, and this calculation also factors in any capital gain or loss that could result if the bond is sold at maturity. For those that hold a bond directly, this metric can be used to determine what the annual yield of the bond would be until maturity. For ETFs, it’s more complicated, since bonds are typically not held until maturity; however, it does provide some guidance of the internal go-forward yield the ETF might be earning in the future.

Effectively, if an ETF pays out a fixed payment, then the current yield can remain somewhat high while the actual internal yield, typically measured by the weighted average yield-to-maturity, can be much lower. Effectively, these ETFs may be tapping into the capital of the ETF to fund income. You might find that, come tax time, a portion of the return is actually return of capital.

This is an industry-wide issue and we have also identified this issue internally. We have an ETF where the current yield is quite a bit higher than its portfolio’s weighted average yield-to-maturity: the Horizons Ultra-Short Investment Grade Bond ETF (HFR) has a current annualized yield of 2.58% but the weighted average yield to maturity is 1.11%, as at February 28, 2021. At some point, the current yield will have to come down to reflect the lower yield being earned in the portfolio.

HFR has a current duration of 0.66 (as at February 28, 2021). It may be surprising, but, at 1.11%, HFR is actually paying a distribution rate that is quite attractive when compared to other fixed income strategies that have a duration of less than one year, making it a potentially defensive strategy against rising interest rates. However, investors could misconstrue that the strategy is going to yield 2.48%, which would put its closer to higher yield strategies. This type of risk/reward simply doesn’t exist in fixed income right now.

How Can Investors Potentially Deal with Declining Yields and Prices?

There is, admittedly, no simple answer. Investors seek to find a balance between generating a yield with a risk profile that makes sense for them. For this reason, we recommend they look at three different key areas of their fixed income strategy:

1) Credit Quality: What is the default rate on the bonds? BBB or above are considered investment-grade, while higher yields can be found in bonds that have BB or below, but the credit risk increases substantially. Keep in mind that BB yields look like investment-grade yields from only two or three years ago, so everything is relative based on current interest rates and yields.
2) Weighted Average Yield-to-Maturity: Again, this is probably a more accurate metric of what the ETF will earn on a go-forward basis. If interest rates rise, the actual yield by the ETF could end up being higher, but the YTM provides a decent baseline.
3) Duration: This reflects the interest rate risk of the strategy. The longer the duration, the likelier there could be a higher yield on the strategy; however, there could be also be a higher likelihood that losses in the value of the bonds in the portfolio could occur if rates increase.

For investors, a good course of action may be to look at all three of these metrics and find the best balance that meets their risk-return objectives. Finding a strategy with a relatively low duration, but a higher yield-to-maturity and credit rating than other offerings in its category, could be a powerful way to navigate an increasingly volatile fixed income market.

HFR Investment Objective
The investment objective of Horizons HFR is to generate income that is consistent with prevailing Canadian short-term corporate bond yields while reducing the potential effects of Canadian interest rate fluctuations on Horizons HFR. Horizons HFR invests primarily in a portfolio of Canadian debt (including debt-like securities) directly, and hedges the portfolio’s interest rate risk by maintaining a portfolio duration that is not more than one year. Horizons HFR may also invest directly in debt of U.S. companies, as well as indirectly through investments in securities of Listed Funds. Horizons HFR uses derivatives, including interest rate swaps, to deliver a floating rate of income.

HFR Performance


Source: Horizons ETFs, as at FEBRUARY 28, 2021
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 shown are not indicative of future returns. The ETF is not guaranteed, it’s value changes frequently, and past performance may not be repeated.

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 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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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.