ETF News

The ETF industry is constantly evolving, adapting to market trends and investor demands for innovative solutions. Recent developments in the Canadian ETF market reflect these shifts, particularly in response to changing economic conditions and the quest for new investment strategies.

For instance, the launch of Canadian Treasury bill (T-bill) ETFs in April 2023 marked a significant development, offering investors a safer alternative to traditional bond ETFs. This was especially relevant during periods of rising interest rates, where bond ETFs experienced heightened volatility. During this time, T-bill ETFs emerged as a viable option for investors seeking to reduce risk.

Another segment that gained traction during the bear market of 2022 was covered call ETFs. These products became increasingly popular due to their potential for higher income generation. Covered call strategies involve holding a portfolio of stocks while selling call options on the same stocks, which can provide additional income through the premiums received.

Capitalizing on the popularity of T-bill ETFs and covered call strategies, Canadian ETF providers like Hamilton ETFs, Harvest ETFs, and Horizons ETFs have innovatively combined these two concepts.

They have launched covered call bond ETFs, which apply the covered call strategy to fixed-income securities. This novel approach aims to provide investors with higher yields while mitigating the volatility typically associated with bond investments in a rising rate environment.

These products represent a new frontier in fixed income investing, offering a unique blend of income generation and risk management, but as with any new product, there's a learning curve to navigate.

What are Covered Call Bond ETFs?

While covered calls are typically associated with stocks, this strategy can be effectively applied to bonds, particularly through options on highly liquid U.S.-listed bond ETFs.

This strategy involves selling call options on the ETF, which grants the buyer the right, but not the obligation, to purchase the ETF at a predetermined price (the strike price) within a specified time frame.

In return for selling this right, the ETF receives a premium, which provides additional income to the fund and its investors.

One key advantage of this strategy is the potential for higher income. By selling call options, covered call bond ETFs generate income from the option premiums on top of the existing bond ETF's yield.

This approach can help enhance the yield of a bond portfolio, offering a “paid to wait” advantage while central banks like the Federal Reserve and the Bank of Canada navigate their monetary policies.

Moreover, covered call bond ETFs can outperform in sideways markets. In such market conditions, where volatility is high, yet price movements are rangebound, income from option premiums can provide a steady stream of returns. This strategy is well-suited for investors who are looking for higher income while maintaining a conservative risk profile.

However, it's important to note that this strategy has its limitations. In a scenario where interest rates decrease and bond prices rise significantly, the performance of covered call bond ETFs might lag. This is because the sold call options cap the upside potential of the ETF; if the underlying bond ETF's price exceeds the strike price of the call options, the additional gains are not realized beyond the option's strike price. Therefore, in a rapidly appreciating bond market, these ETFs might underperform compared to traditional bond ETFs without a covered call strategy.

The Current Covered Call Bond ETF Lineup

The first to launch these new ETFs was Hamilton ETFs on September 15th. The firm debuted the actively managed Hamilton U.S. Bond Yield Maximizer ETF (HBND), which wraps five other highly liquid U.S. Treasury ETFs across the yield curve while selling at-the-money calls on 50% of the portfolio. Hamilton expects a 10% target yield, along with monthly distributions.

Meanwhile, income specialist firm Harvest ETFs launched the Harvest Premium Yield Treasury ETF (HPYT) on September 28th, and it has since reached $93 million in assets. This ETF is projecting a 15% yield by writing covered calls on 100% of its underlying holdings, which are also U.S.-listed Treasury ETFs, but with a focus on longer-maturity issues.

Finally, Horizons ETFs also debuted a lineup of three covered call bond ETFs for investors who wish to slice and dice their fixed income exposure more precisely across the yield curve. They include the Horizons Short-Term U.S. Treasury Premium Yield ETF (SPAY), the Horizons Mid-Term U.S. Treasury Premium Yield ETF (MPAY), and the Horizons Long-Term U.S. Treasury Premium Yield ETF (LPAY).

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.