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Shorter-Duration Bond Funds Gain Steam As Rates Continue To Rise

Monday, November 14, 2016 7:57
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From Todd Rosenbluth: After falling below 2.0% for much of 2016, the yield on the 10-year Treasury bond moved back above that perch following recent expectations that the Federal Reserve would raise rates soon, not to mention the surprise election of Trump.

We think with the ongoing uncertainty, advisors and investors planning for 2017 need to understand the interest rate sensitivity of funds they hold or are considering buying.

When rates move higher, bond values typically move lower. The degree of how much bonds move tied to interest rates can be measured using duration. Simply, when interest rates rise 100 basis points (i.e. from 0.00% to 1.00%), a portfolio of bonds with an average duration of seven years is expected decline by 700 basis points as yields move notably higher, while a portfolio of bonds with duration of two years should fall only 200 basis points.

Government bond ETFs were been popular with investors in the first ten-plus months of 2016, but primarily those with intermediate term exposure. Approximately $8 billion of net new money flowed into intermediate-term products year to date through November 4, triple the amount that went into short-term and ultra-short-term ETFs according to SSgA. One popular intermediate term ETF is iShares 3-7 Year Treasury (IEF 107 Marketweight), which has an average duration of 7.6 years.

However, in the one-month period ended November 4, ahead of the election, those shorter-term government bond products gathered $1.1 billion in new assets much more than the $265 million pulled in by intermediate term ones.

In analyzing fixed income ETFs from a holdings perspective, we assess the duration, credit quality and yield of an ETF. This is combined with expense ratio, bid/ask spread and liquidity to form our three-tiered ranking. The ETF’s three-year track record is not used since especially in the bond market, past performance is tied to how the ETF was positioned during a different fixed-income environment.

On MarketScope Advisor, there are 27 Overweight-ranked bond ETFs with an average duration of less than three years.

One such short-term ETF is iShares 1-3 Year Treasury (SHY 85 Overweight), which has a 0.15% expense ratio. SHY has duration of 1.9 years and offers a 0.7% 30-day SEC yield. The ETF trades more than two million shares on a daily basis with a penny bid/ask spread. The ETF’s credit quality is relatively strong compared to other fixed-income products.

For those investors who want a similar level of interest-rate sensitivity, but seek a greater yield, there are other strong passive and active ETF choices to consider.

SPDR Bloomberg Barclays Short-Term High Yield Bond (SJNK 27 Overweight) has duration of 2.4 years, but sports a 5.6% yield. Not surprisingly, the bonds inside SJNK incur more credit risk than SHY with speculative-grade bonds. For example, SJNK recently held 44% in bonds rated BB and 30% in bonds rated B. The ETF trades on average 1.9 million shares on a daily basis, also for a penny spread, but has a higher 0.40% expense ratio.

While SHY and SJNK seek to replicate an index, PIMCO Enhanced Short Maturity Active ETF (MINT 101 Overweight) can shift its exposure based on management’s discretion. Despite duration of 0.26 years, MINT’s 30-day SEC yield was 1.2%. The ETF holds primarily investment-grade corporate bonds, issued by U.S. companies, such as Goldman Sachs and Time Warner Cable, and foreign companies, such as Electricite de France.

MINT has a 0.36% expense ratio and trades approximately 485,000 shares on a daily basis, but with a wider spread than the above ETFs.

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