Exploring the use cases for covered call bond ETFs

CIO & Portfolio Manager explains how advisors are using these ETFs since their launch late last year

Exploring the use cases for covered call bond ETFs

As with any novel strategy, market absorption and utilization takes time. That is especially the case when a strategy upends some of the traditional perceptions of an asset class as longstanding as fixed income. In Q4 last year, Canadian ETF issuers launched a spate of high yielding bond ETFs. These ETFs held allocations to large US-listed bond ETFs while writing covered call options on those holdings. The result was a set of products which offered somewhat muted NAV return, but delivered far higher yields than their underlying exposures could.

To understand where these strategies are fitting into client portfolios, WP spoke with Paul MacDonald, Chief Investment Officer and portfolio manager at Harvest ETFs. Harvest now offers a pair of covered call fixed income ETFs under the tickers HPYT and HPYM. HPYT offers longer-duration exposure, while HPYM targets a 7-10 year duration. MacDonald explained that these products have become a useful cashflow generator for advisors, in part because they offer a level of duration compensation that cannot be achieved in our current inverted yield curve. Perhaps more simply, they have become a useful complement to fixed income exposures for retirees because they pay a real yield well in excess of inflation.

“It comes down to total cashflow,” MacDonald says. “If you adjust for inflation going forward your real yields are at around one percent when you see a three and a half per cent inflation rate and a four and a half per cent yield. Your cash flows are not necessarily as robust as they appear when you look at the nominal rate.”

MacDonald emphasizes that the additional cash flow may be particularly attractive to retired or retiring clients, given the likelihood that inflation will rest at a higher rate going forward than it did prior to the onset of the COVID-19 pandemic. The intention behind a product like these covered call bond ETFs is to contribute to the cashflow side of a client’s fixed income portfolio, with yields typically in the double digits.

Some of the utility behind these products is tied to our currently unique moment in fixed income markets. After over a decade of zero interest rate policy (ZIRP) fixed income became a source of capital preservation and appreciation for investors. Following the sudden and sharp increase in interest rates that began in 2022, we have now seen shockingly high levels of volatility in fixed income. Today, even as the US Federal Reserve appears to hold its interest rate steady, we are seeing a huge amount of sensitivity from bond investors to signals that the Fed may delay their expected interest rate cuts. With that sensitivity comes volatility.

Because covered call premiums are higher when volatility levels are higher, these ETFs can actually earn a higher level of cashflow during periods like the one we’re in now. Another hallmark of this current period is that the yield curve is inverted. Investors are being paid less yield for longer duration holdings than shorter duration bonds. MacDonald says that the extra yield that covered calls generate on these ETFs can help compensate investors for a longer yield exposure.

While the cashflow function of these ETFs may be apparent, it’s notable that they are similarly subject to the volatility we now see in the bond market. MacDonald explains that their NAV may move up and down in line with what the wider bond market has experienced in recent years. After a decade of ZIRP many investors are of the view that bond ETFs should show very little fluctuation, but given today’s level of volatility that may no longer be the case. Cashflow, however, can help offset that volatility, especially with these products offered as a complement to traditional fixed income holdings.

“These are cashflow products, first and foremost,” MacDonald says. “You have to factor in that cashflow from a total returns basis. And maybe there’s some capital appreciation that comes with that, but when we think about fixed income we’re thinking about the income.”