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.”
