New Opportunities for HISA ETF Holders
While high interest savings account (HISA) ETFs have largely flown under the radar since their inception in Canada close to 10 years ago, interest rate spikes over the last year have landed these products in the investment spotlight for the first time.
And why not? HISA ETFs offer a risk-free portfolio of bank accounts spread across several institutions. They are liquid and flexible, and come with competitive annualized distribution yields in excess of the overnight rate and recent money market yields, which were 5% as of January 2024. That makes these funds an ideal vehicle for investors who want to park their cash until smoother markets prevail.
Today, HISA ETFs have attracted almost C$30 billion in assets and make up between 7% and 8% of the entire ETF market. (Source: National Bank ETF Report, January 2024).
Banks have been offering traditional access to HISA accounts for many years. These accounts attract “sticky money”; deposits made by retail investors that are likely to sit in an account for an extended period of time. This structure has enabled banks to easily lend out those deposits and earn a premium on these loans.
The innovation of providing access to these accounts via ETFs has been a boon for investors, but it has also caused regulators to evaluate how banks lend these deposits out going forward.
OSFI, the Office of the Superintendent of Financial Institutions, conducted an industry-wide consultation this year to determine if HISA ETFs posed a risk to the overall financial system. Given the vast sum of funds invested in these products, they determined that it did. Their concern centered around an unlikely scenario, where a quick drop in assets could create a liquidity issue for the institutions loaning out these cash reserves.
To remedy this concern, OSFI decided that investments in HISA ETFs should be treated as wholesale funding, not retail deposits. This means the capital accumulated from these funds cannot be lent out without banks amassing appropriate collateral.
The significance of this ruling will have an immediate impact when new OSFI regulations kick in on January 31st, 2024. As a result, HISA ETFs will no longer be able to pay a premium for the deposits they collect, causing a drop in yield that is expected to be about half a percent.1
But there is no need for panic. HISA ETFS will maintain their cash-like characteristics. The only thing that will affect investors is the yield they receive on these ETFs, not liquidity. Still, investors who want to maximize yields while maintaining a similar risk profile and liquidity will now be forced to look elsewhere. This will bring two main opportunities into play: money market ETFs, and ultra short-term bond ETFs.
Money market funds have been a go-to product for investors looking to park cash outside of the equity market since the early 1990s. They consist of short-term debt securities such as treasury bills, commercial paper, and certificates of deposits. BMO ETFs offer investors the BMO Money Market Fund ETF (ZMMK) with a yield that is expected to be 25 to 30 basis points above the over night rate and expected HISA ETF yield once the new regulations take effect at the end of January, assuming current rates and credit spreads hold.
The other option investors can consider is the BMO Ultra Short-Term Bond ETF (ZST). This bond fund offers an additional upside potential of about 25 basis points over traditional money market funds, (if current credit spreads and rates hold), with a slightly elevated risk. It consists of corporate bonds issued by high-quality companies like the banks and telcos. Each bond matures within a year, further diminishing the unlikely risk of a default.
In addition to the interest these ultra short-term bond funds provide, they offer the potential of capital appreciation, which generates capital gains taxed at more favourable rates when held within a non-registered account. Together, these factors can help generate a highly competitive yield.
Ultra short-term bond ETFs such as ZST have an added benefit for those holding these ETFs in non-registered accounts. Many of the bonds held in these ETFs are discount bonds, meaning they are trading below par value. However, because the bonds mature in less than a year, they will be pulled to par value within by that time, creating an element of capital gains in the ETF portfolio. This in turn creates a more tax efficient distribution for taxable accounts.
It should be noted that most income received from HISA ETFs and Money Market ETFs is taxed as interest income.2
The BMO Money Market Fund ETF (ZMMK) and BMO Ultra Short-Term Bond ETF (ZST) can be purchased like any other ETF, either from your online direct investing account, or through your advisor. To learn more, visit https://www.bmogam.com
1TD Securities, October 2023. 2 Please consult a tax professional with respect to any circumstance.
Annualized Distribution Yield: This yield is calculated by taking the most recent regular distribution, or expected distribution, (excluding additional year end distributions) annualized for frequency, divided by current NAV. The yield calculation does not include reinvested distributions.
ZMMK’s performance as of December 31 2023: 1 month 0.44%, 3 month 1.32%, 6 month 2.59%, 1 year 4.97%, since inception annualized 3.32%.
ZST’s performance as of December 31 2023: 1 month 0.46%, 3 month 1.54%, 6 month 2.84%, 1 year 5.32%, 3 year annualized 2.22%, 5 year annualized 2.17%, 10 year annualized, 1.80%, since inception annualized 1.91%.
To read OSFI’s full report on the updated liquidity requirements for HISA ETFs, click here.
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