For over a year now, probably longer, market participants have been trying to pin down exactly when the Federal Reserve is going to raise interest rates.
Fed fund futures currently assign a better than 55% probability that the Fed boost rates following the upcoming June 17 meeting. Fixed income investors betting that a rate hike is imminent should move to the shorter end of the yield curve, a task that can be accomplished with exchange traded funds, such as the iShares 1-3 Year Treasury Bond ETF (NYSEArca: SHY).
“This fund’s current SEC yield is comparable to what you might currently get from a three- to six-month CD from your local bank, but, unlike CDs, there are no early withdrawal penalties. The fund also will not offer the principal and interest-rate guarantees of a CD. Another thing for investors to consider is the transaction costs involved with moving in and out of this fund. Given the very low expected returns, investors frequently trading in and out of this fund run the risk of eating up their returns,” writes Morningstar’s John Gabriel.
A flatter yield curve illustrates an environment where the yield difference between short- and long-term debt securities begin to shrink.
The $9.1 billion SHY has a 30-day SEC yield of just 0.42%, but that this is the tradeoff for gaining access to the ETF’s modest effective duration of 1.77 years. The yield and bond’s price have an inverse relationship, so bond funds with long durations would experience large price drops if rates were to rise. In contrast, short-duration bond funds will experience more muted volatility in case of sudden rate changes. [Focus on Short Duration Bond ETFs]
By moving down the yield curve, short-duration bond ETFs will experience smaller swings in a rising rate environment. For instance, a 1% rise in interest rates would only correspond to modest, if any, losses for ETFs like SHY. With an expense ratio of just 0.15%, SHY is a cost-effective option for the fixed income investor looking to fight the scourge of rising rates. [Bond ETFs on the Cheap]
“The fund’s costs are competitive with other exchange-traded funds, but considering that the yield to maturity on the portfolio is 0.59%, expenses swallow about a fourth of the portfolio’s income. This fund has done an excellent job tracking its index. It has an estimated holding cost of only 0.12%,” according to Morningstar.
Investors have warmed to the SHY story, pouring over $1 billion into the fund this year. Enthusiasm for the ETF has accelerated in the current quarter as more than $1.4 billion has flowed into the fund since April 1.
iShares 1-3 Year Treasury Bond ETF