Hamilton Launches Canada's First Covered Call Bond ETF
Canadian ETF issuers continue to innovate, with Hamilton's latest offering serving as a great example.
Back in February, I wrote a comprehensive two-part series (Part 1, Part 2) on all the different Canadian ETF issuers that currently offer covered call ETFs.
Since the 2022 bear market, there has been a notable increase in demand for these products. Investors seeking steady income have shown interest, and in response, ETF issuers have rolled out high-yield products across various equity sectors and indexes.
In a notable move, Hamilton ETFs has launched Canada's first covered call ETF that uses bonds as its underlying asset, the Hamilton U.S. Bond Yield Maximizer ETF (HBND).
Launched on September 15th, this ETF targets consistent monthly income by focusing on U.S. treasuries via a portfolio of different of bond ETFs. To enhance its income potential and manage risk, HBND also implements a covered call strategy.
Let's revisit the concept of covered calls and take a closer look at the specifics of HBND.
Refresher on covered calls
Covered calls, in the simplest terms, are an options strategy that allows investors to transform the potential upside of an asset into an immediate cash payout.
When an investor writes (or sells) a covered call, they are selling someone else the right (but not the obligation) to buy a stock (or another asset) they own at a predetermined price (the strike price) within a specified time period.
In return for this right, the call buyer pays the seller a fee known as the premium. Several factors determine the size of this premium:
- Volatility: The more volatile a stock or asset is, the higher the premium typically is. This is because volatility increases the chance of the stock price moving beyond the strike price.
- Time: The longer the time until the call option expires, the larger the premium. This is due to the time value of money.
- Strike Price: Options with strike prices closer to the current market price (at-the-money) often have higher premiums compared to those with strike prices far away from the market price (out-of-the-money).
The perfect scenario for someone who writes a covered call is a flat market or one with high volatility. If the market stays flat, the option will likely expire worthless, and the seller gets to keep the premium without having to sell the underlying asset. In high volatility scenarios, the higher premiums can compensate for potential losses or lower gains on the underlying asset.
It's crucial to emphasize that covered calls don't inherently amplify returns; they merely modify the risk-return profile of the underlying asset.
While a long-only strategy offers unlimited upside potential and bears the full brunt of downturns, a covered call strategy provides a buffer against mild declines and an immediate cash payout in the form of a premium. However, it also limits upside potential.
Investors need to weigh these trade-offs when considering which strategy aligns with their risk tolerance and financial goals.
HBND breakdown & analysis
It's essential to recognize that covered calls aren't confined to equities alone. Many investors don't realize that this strategy can be applied to a plethora of assets via the ETF structure.
These ETFs might hold a variety of assets, from commodities such as gold to even bonds. While covered call bond ETFs have been available in the U.S. market, it's only now, thanks to HBND, that Canadian investors can tap into this opportunity.
HBND itself is structured as an "ETF of ETFs". By wrapping around five other US-listed ETFs that focus on Treasuries across various maturities, HBND provides diversified exposure to the U.S. Treasury market. As of September 14, the portfolio composition is:
- TLT (iShares 20+ Year Treasury Bond ETF): 50.0%
- VGLT (Vanguard Long-Term Treasury ETF): 30.0%
- VGIT (Vanguard Intermediate-Term Treasury ETF): 10.0%
- SCHO (Schwab Short-Term U.S. Treasury ETF): 5.0%
- BIL (SPDR Bloomberg 1-3 Month T-Bill ETF): 5.0%
HBND then actively writes at-the-money (ATM) covered calls on 50% of the ETF's portfolio, which offers two main benefits:
- ATM Options: ATM options typically carry higher premiums compared to out-of-the-money options, as they have a higher probability of being exercised. This results in immediate and potentially higher cash inflow for the ETF.
- 50% Overlay: By choosing to write covered calls on only half of the portfolio, the ETF preserves some upside potential. If the underlying assets rise significantly, 50% of the portfolio can still capture those gains unencumbered.
Further, opting for an actively managed covered call strategy instead of a systematic approach allows HBND's managers to be nimble. They can adjust their call writing based on market conditions, trends, and forecasts, rather than adhering strictly to a predetermined algorithm.
In terms of costs, investors are looking at a 0.45% management fee. Additionally, the ETF aims to provide a 10% target annual yield, making it an attractive option for those looking for consistent income.
Given the current market scenario, a sideways trading yet volatile Treasury market seems like a reasonable expectation. This is especially true considering the ongoing Federal Reserve interest rate hiking cycle and the recent downgrades by Fitch Ratings.
In such a scenario, HBND could be a solid choice. Its strategy implies that investors essentially "get paid while they wait" for a potential rate cut. This aligns with the ETF's current focus on longer duration Treasury issues, anticipating a rate cut in the foreseeable future.
Please note this article is for information purposes only and does not in any way constitute investment advice. It is essential that you seek advice from a registered financial professional prior to making any investment decision.
