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ETF Specialist

An ETF for Those Seeking Safety at the Short End of the Yield Curve

If preserving principal in the near term is an investor’s primary objective, then this fund will likely do the trick.

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 IShares 1-3 Year Treasury Bond (SHY) provides exposure to a portfolio of short-term Treasury bonds and, as of the beginning of April 2016, had an average duration of 1.9 years. Treasury bonds are full faith and credit obligations of the U.S. government and thus carry minimal credit risk. That said, the fund can suffer modest fluctuations in net asset value when short-term rates move sharply and is thus not a perfect substitute for a cash account.

Bond prices have an inverse relationship to interest rates. As a result, if bond yields go up, bond prices go down. SHY's 1.9-year duration implies that if yields on short-term Treasuries rise 1 percentage point, then the value of SHY's portfolio will decline by about 1.9%. In the fourth quarter of 2015, for example, the fund lost 48 basis points as short-term yields increased in anticipation of the Federal Reserve’s December 2015 25-basis-point rate hike, its first in nearly a decade.

Investors looking for a short-term haven could also consider a short-term CD. Unlike CDs, the fund does not have early withdrawal penalties, but it will not offer the principal and interest-rate guarantees of a CD. Investors should also consider transaction costs. Given low yields and correspondingly low expected returns, frequent trading in and out of this exchange-traded fund could take a significant bite out of returns.

Fundamental View
Short-term U.S. Treasury bond yields are highly sensitive to changes in expected Federal Reserve policy. After years of keeping policy rates near zero in the wake of the credit crisis, the Federal Reserve hiked short-term rates by 25 basis points at its December 2015 meeting. As a result, short-term U.S. Treasury bond yields have increased significantly in the past year. As of April 5, 2016, two-year Treasury rates stood at 0.73%, up from 0.67% at the end of 2014.

By historical standards, however, the fund's current yield is still relatively low. Over the decade ended March 2016, the two-year Treasury yield traded as low as 0.16% (September 2011) and as high as 5.3% (June 2006), and it averaged 1.3% over the entire period. With yields still near the low end of that range as of the beginning of April, there's little room for  price appreciation. 

The Federal Reserve has indicated that it expects to continue to raise rates, albeit at a gradual pace with any increases dependent on economic data, including the unemployment rate and inflation. The Federal Open Market Committee members’ estimates of the long-run rate of normal unemployment range between 4.7% and 5.8%; the unemployment rate of 5.0% as of March 2016 was at the low end of that range. However, core personal consumption expenditure inflation continues to run under the Federal Reserve’s 2% stated target.

The biggest risk associated with short-term Treasuries is the potential for a steady increase in short-term bond yields. However, given the bonds’ limited duration, any losses are likely to be modest compared with longer-maturity bonds and investors will quickly benefit from increased yields.

Investors seeking shelter from the impact of higher interest rates on their bond portfolio should consider the trade-off that comes with the fund's limited interest-rate risk. Because the yield curve is typically upward sloping, investors give up yield in exchange for less interest-rate risk. As a result, although longer-term bonds are more sensitive to changes in bond yields, they do offer more total return potential.

If preserving principal in the near term is an investor’s primary objective, then this fund will likely do the trick, although it is vulnerable to modest short-term losses when short bond yields rise. The fund can be an effective short-term safe haven.

Portfolio Construction
Effective March 31, 2016, iShares changed the underlying index for this fund from the Barclays U.S. 1-3 Year Treasury Bond Index to the ICE U.S. Treasury Bond 1-3 Year Index, part of the ICE U.S. Treasury Index Series administered by Interactive Data. This shouldn't result in a significant change to this fund, which will continue to track the short-term sector of the U.S. Treasury market. Indeed, the indexes are very similar, with only modest differences. So, for example, in the ICE Treasury Bond Index Series, secondary market purchases and sales are adjusted at month-end; the Barclays U.S. Treasury Bond Index Series makes these adjustments with a one-month lag. The 2.44% 10-year annualized return of the ICE U.S. Treasury Bond 1-3 Year Index through Dec. 15 was identical to that of the Barclays U.S. 1-3 Year Treasury Bond Index, and returns for the two indexes over the trailing one-, three-, and five-year periods were within a couple of basis points of each other. The fund employs a sampling strategy to assemble its portfolio of Treasury bonds, typically investing 90% of its assets in the bonds in the index and at least 95% of its assets in government bonds. It tracks its narrowly focused benchmark with a portfolio of around 100 securities, and its duration stood at 1.9 years as of April 1, 2016. The fund pays distributions on a monthly basis.

Fees
The fund has a low expense ratio of 0.15%. The fund's costs are competitive with other ETFs, but considering that the fund’s weighted average yield to maturity was 0.78% as of April 18, 2016, expenses swallow about one fifth of the portfolio's income. This fund has done an excellent job tracking its index. Over the past decade through March 2016, the fund trailed its benchmark by 0.13% annually, which is right on par with its management fee. 

Alternatives
 Vanguard Short-Term Bond ETF (BSV) is an even cheaper option, with an expense ratio of 0.10%. However, BSV has a slightly more aggressive risk profile with a 2.7-year duration as of February 2016 and roughly one fourth of the portfolio dedicated to corporates. As a result, it had a higher yield as of March 2016 in exchange for additional credit and interest-rate risk. IShares also offers the  iShares 1-3 Year Credit Bond (CSJ), which, as its name suggests, invests in corporate bonds as well as foreign sovereign, supranational, and taxable munis but has a similar duration profile. That fund also sported a 15-basis-point expense ratio.


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Sarah Bush does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.