Harvest ETFs explores the role of covered call U.S. Treasury ETFs and income strategies amidst rate cuts
This article was provided by Harvest ETFs.
After months of anticipation, the Federal Reserve (Fed) finally initiated its long-awaited easing cycle with a 50-basis-point rate cut in late September. The reaction was swift—equity markets surged, led by a 1.7% rally in the S&P 500, with tech stocks taking the spotlight.
For many investors who have relied on the safety of cash and money market funds, offering 5% yields, the news was a sobering reminder that such returns won’t last. With another 75 basis points in cuts expected before the year’s end, those attractive yields on parked cash are set to dwindle, leaving advisors scrambling to preserve income for their clients. But this rate-cutting cycle is opening new doors—especially for bond-based strategies that can navigate a lowering yield environment.
Most client books are split between equities for capital growth and fixed income for stability and income generation. Advisors are tasked with balancing both growth and income-oriented portfolios for their clients. Harvest ETFs, long recognized for its Equity Income lineup, which marries growth potential with high monthly income from covered calls, saw a unique opportunity in September 2023.
Anticipating the market's shifting dynamics, Harvest ETFs introduced the Harvest Premium Yield Treasury ETF (HPYT) to meet the growing demand for stability, high income, and tax efficiency. One year later, as the ETF marks its first anniversary on the TSX, HPYT continues to deliver.
Shifting from cash to bonds: Why U.S. treasuries now?
While equities may be riding high on the Fed’s latest rate cut, fixed income is where the longer-term story unfolds. U.S. Treasuries, particularly longer-dated bonds, are poised to benefit from the new downward rate trajectory.
Historically seen as a safe haven, U.S. Treasuries offer stability that is especially attractive during periods of uncertainty. But with rates now falling, the value of these bonds could rise, making them an attractive core holding for investors who are looking to take advantage of the interest rate change in their portfolios. However, HPYT still offers value outside of this scenario due to its ability to generate high monthly income through call option premiums. That high income, paid in a monthly cash distribution of $0.15 per unit, can offset a continued drawdown in US Treasury bond prices.
For investors who have been relying on money market funds, the appeal of U.S. Treasuries is growing as short-term rates and cash account yields fall.
U.S. Treasury ETFs that invest in longer-dated U.S. government bonds provide both stability and an opportunity for capital appreciation, especially in the current interest rate environment. Backed by the U.S. government, these bonds carry top-tier credit ratings. However, in the midst of the Fed's recent rate cuts, these bonds offer more than just security; they are positioned to capture potential gains as yields compress, driving up bond prices.
Harvest ETFs portfolio manager Mike Dragosits explains, “The long-term bond yields have already done a lot of the heavy lifting to price in the anticipated interest rate cutting cycle. This is especially true given the expected return to a normal upward-sloping yield curve and the decline of 137 basis points on the 10-year bonds, which are now at 3.65%.” This shift reflects the larger moves in yields across the curve, particularly when compared to the yield levels seen in April 2024 after a brief economic uptick.
Looking ahead, the yield curve is expected to normalize due to several factors, including the conclusion of the tightening cycle and the Fed’s new rate-cutting stance. According to Dragosits, this normalization will likely result in short-term bond yields falling faster and staying relatively lower than long-term bond yields.
While this rate regime transition brings near-term uncertainty—exacerbated by the upcoming U.S. presidential election cycle—it also creates greater opportunity to capture elevated option premiums through covered call writing. The market volatility that typically accompanies such transitions allows for higher premiums, enhancing income generation.
For strategies that employ covered call writing on ETFs holding longer-dated U.S. Treasuries, like HPYT, falling yields can be a double-edged sword. If yields continue to fall, bond prices may experience upward movement, benefiting the net asset value of ETFs like HPYT for the portion of the ETF not capped by written call options. Covered call strategies adjust these caps monthly, resetting strike levels based on price movement, making steady, gradual yield changes the most favorable environment.
That said, higher bond duration also brings sensitivity to even small rate changes, which can introduce volatility in the NAV. As Dragosits notes, while volatility can pose challenges, it also allows for higher premiums on call options, which enhance income generation. The delicate balance between managing NAV fluctuations and maximizing option premiums is key to achieving the high monthly cash flow that these strategies are designed to deliver.
High monthly income and tax efficiency that matters
While being exposed the stability of U.S. Treasuries is a key strength, HPYT’s defining feature is its ability to deliver consistent monthly income. Since its inception, HPYT has provided monthly cash distributions of $0.15 per unit, resulting in an impressive yield of 16.1% (as at September 30, 2024). In its first year, HPYT has grown over C$500 million in assets under management (AUM).
In non-registered accounts, the income generated through covered call writing can be treated as capital gains, which are taxed at a lower rate than bond interest or dividends. This allows advisors to optimize the after-tax returns for their clients, making HPYT a particularly attractive choice for those looking to preserve income without a hefty tax bill.
This tax-efficient structure helps investors maintain income without venturing into riskier strategies, such as junk bonds, which might otherwise be needed to achieve similar pre-tax yields.
By combining the stability of U.S. Treasuries with a strategy that generates high monthly income, HPYT is an ETF that fits the moment.
