Credit: Shutterstock photoThe two biggest risks that bond investors face are rising inflation and rising interest rates. This dual threat has been moderated for many years now as global central banks set accommodative policies to boost asset prices. The ultimate result of which has been tame inflationary metrics, steady jobs growth, corporate earnings expansion, and firm declines in Treasury yields.
The more recent roundabout (or tightening) of Federal Reserve fiscal policy has created a unique environment for bond investors to evaluate. Namely a flattening yield curve, whereby the 2-year U.S. Treasury Yield is sharply rising compared to its 10-year and 30-year counterparts.
2-Year Treasury Yields just touched a new cycle high of 2%, which is the highest level in nearly a decade. For comparison purposes, the 10-Year Treasury Yield is currently 2.55%, just 55 basis points higher. This narrow variance puts risk in a whole new light for fixed-income investors. Namely, those who are holding higher duration securities with greater sensitivity to interest rate fluctuations are being paid little in additional yield premium for taking on this risk.
A perfect example is the $53 billion behemoth that is the iShares Core U.S. Aggregate Bond ETF (AGG). This well-known index fund tracks the Bloomberg Barclays US Aggregate Bond Index, which includes over 6,500 securities with an effective duration of 5.79 years. AGG sports a 30-day SEC yield of 2.45% as of current prices.
This low-cost index fund, and others like it, are common fixtures of core portfolio bond allocations. They are designed to be representative of the U.S. fixed-income market, which means they are heavily weighted towards Treasuries, mortgage-backed securities, and high quality corporate bonds.
Yet with the sharp rise in the “short-end” of the yield curve, there now exists similar opportunities for income with significantly less interest rate risk. One instance of this strategy from the same fund family is the iShares Core 1-5 Year USD Bond ETF (ISTB). This fund sports a highly diverse basket of nearly 3,000 U.S. sovereign and investment-grade corporate bonds with a current 30-day SEC yield of 2.35%. The intriguing aspect of ISBT is its much lower effective duration of just 2.68 years. Less than half that of AGG.
Another option for investors in high tax brackets to consider are short-term municipal offerings. The SPDR Nuveen Bloomberg Barclays Short Term Municipal Bond ETF (SHM) is currently yielding 1.46% with an adjusted duration of 2.81 years. According to State Street, the taxable equivalent yield of SHM is 2.58% given the supposition of a 35% Federal rate and 6.85% state tax rate.
Of course, there is always the option of moving down the credit spectrum as well. The iShares 0-5 Year High Yield Corporate Bond ETF (SHYG) owns a basket of over 600 junk bonds from below-investment grade corporate issuers. This ETF has a 5.12% yield along with an effective duration of just 2.10 years. While this may seem enticing to those stretching for additional income, it’s worth noting that these ETFs tend to be highly sensitive to global risk conditions.
The Bottom Line
Many investors will opt to stick with their current bond allocations given a long-term mindset and the unpredictability of interest rate fluctuations. Nevertheless, more active participants may opt to use one or more of these alternatives to shorten duration while simultaneously keeping similar credit quality, income, and diversification guidelines intact.
Shorter duration funds also carry the potential risk of underperforming if interest rates peak and begin to decline once again. Those that do opt to make a change to their ETF holdings may want to consider doing so in incremental steps or by keeping a portion of their existing positions intact.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
