Half a dozen fixed-income ETFs are the newest to rely on options writing to generate high monthly distributions. Up until recently, these yield-enhancing strategies — mainly accomplished through covered calls — were found only in equity ETFs.
New offerings from four different firms have arrived in quick succession. Toronto-based Hamilton Capital Partners Inc. was first off the mark on Sept. 14 with the Hamilton U.S. Bond Yield Maximizer ETF, which it touted as Canada’s first covered-call bond ETF. Its initial target yield, from its mostly long-term bond exposure plus option writing, is 10%.
Hamilton’s first-mover advantage was short-lived. In late September, Harvest Portfolios Group Inc. launched the Harvest Premium Yield Treasury ETF, complementing its extensive lineup of covered-call equity ETFs.
Next was Toronto-based Evolve Funds Group Inc., with the Evolve Enhanced Yield Bond Fund, which began trading on Oct. 4. Holding long-term U.S. bond ETFs and employing covered calls, its target yield is 10%.
Horizons ETFs Management (Canada) Inc. upped the ante with its Premium Yield suite of three bond ETFs, which went on sale Oct. 5.
Naseem Husain, senior vice-president and ETF strategist with Toronto-based Horizons, noted that there have been robust sales of covered-call ETFs, and a revival of interest in fixed income. The Premium Yield ETFs play to both these sales trends.
“Not only did we come up with one solution, we said let’s do a suite,” Husain said. “Let’s get short duration, mid duration and long duration.”
The common theme among all the new products is that they invest in the U.S. bond market. And they do so not by holding bonds directly, as most bond ETFs do. Instead, they hold U.S.-listed bond ETFs for which options can be written to generate premium income. Since these premiums are deemed to be capital gains, they’re taxed in non-registered accounts at lower rates than bond interest.
“Because there’s a lot of volatility and uncertainty around where interest rates are going, that translates into very attractive premiums,” said Paul MacDonald, chief investment officer of Oakville, Ont.-based Harvest Portfolios.
“The options are priced off of expected volatility, and so that really does afford us the ability to generate very attractive cash flows from our options strategy but still have exposure to the underlying U.S. Treasuries.”
The Harvest Premium Yield Treasury ETF is positioned at the long end of the yield curve, with a duration of about 16.8 years, so the underlying holdings are highly sensitive to changes in market interest rates.
For example, though considered very unlikely at this point in the rate cycle, a further 100-basis-point leap in long-bond interest rates would translate into a 17% plunge in the value of Harvest’s underlying bond holdings. Options premiums would offset only a portion of those losses.
While acknowledging the risk of rising rates, MacDonald said the tradeoff is higher options premiums for the ETF, enabling it to target a distribution yield of 15%, or roughly triple that of the underlying U.S. bond ETFs it holds. Currently, Harvest is writing options on about 75% of its bond ETF portfolio, and can go as high as 100%.
Catering to a wider range of risk profiles, while still aiming to deliver enhanced distributions, is the trio of Horizons ETFs. On the riskier side is the Horizons Long-Term U.S. Treasury Premium Yield ETF, with a duration exceeding 10 years. Its initial targeted distribution yield is 10.5%, more than double that of the underlying bond ETFs.
This ETF is suitable for investors who want to generate high income along with potential capital appreciation, Husain said. Since bond prices move in the opposite direction of interest rates, long-dated portfolios benefit the most if interest rates decline.
At the other end of the risk spectrum is the Horizons Short-Term U.S. Treasury Premium Yield ETF, with a target duration of less than three years and an initial target annual yield of 7.5%. Holders of this ETF, Husain said, can take advantage of the inverted yield curve, with short-term rates exceeding long-term rates, while getting additional income from the options writing.
Occupying the middle ground is the Horizons Mid-Term U.S. Treasury Premium Yield ETF, with a target duration of five to 10 years. Its target yield, again bolstered by options writing, is 9%.
Unlike the other new enhanced-yield products, Horizons is using both call and put options. Currently, Horizons options strategist Vernon Roberts favours what’s known as straddles, meaning an equal number of call and put options contracts on the same security.
In late October, Roberts held 10% calls and 10% puts on the short-term ETF, and straddles of 15% and 20%, respectively, on the mid-term and long-term ETFs. Straddles produce the best returns for the options writer if the price of the underlying security remains fairly stable.
The fully active Horizons options strategy provides wide latitude to depart from its current emphasis on straddles. If the interest-rate cycle shifts to “where we’re going to get a series of rate cuts,” said Roberts, “we can skew toward writing more puts than calls.” Doing so would leave more of the benefits of rising bond prices in the hands of Horizons ETF investors.
Cutting into some of the returns from options-enhanced strategies are higher management fees than what bond index ETFs charge. Horizons’ fees are 35, 40 and 45 basis points, respectively, for the short-, mid- and long-term ETFs.
Other providers are charging 0.45% for their offerings, though Evolve is waiving its fee until March 31. By comparison, the going rate for broad-market U.S. bond ETFs is 20 basis points, or less than half the cost of an options-enhanced strategy.
Whether to invest in a covered-call bond strategy, especially at the long end of the maturity curve, will be influenced by an investor’s outlook for interest rates.
“If you’re looking at rates staying higher for longer, then covered calls in fixed income makes sense,” MacDonald said. Likewise, in a scenario of rates declining slightly or declining relatively slowly over time, the strategy also works because the options are being written “out of the money.”
In the very bullish case for long bonds, options writing will limit gains. “For most interest-rate environments, the covered call — for those looking to get additional income — does make sense,” MacDonald said, unless the investor expects a steep drop in long-term rates over a short period.