Sleeping with Short Bond ETFs

Bonds and bond funds of short duration come to the fore during times of economic crisis. They are the ultimate destination of a flight to quality, especially if they are Treasury obligations. The graph below shows the total returns over the last three months of a few short bond ETFs as compared with the S&P 500. I use total returns here in order to show the effects of dividends which each of the three bond ETFs pay on a monthly basis.

The three bond ETFs shown are: SSgA’s SPDR Lehman 1-3 Month T-Bills (BIL),  iShares 1-3 Year Treasury Fund (SHY),  andWisdomTree’s Current Income Fund (USY). The WisdomTree offering is the only one that is not exclusively Treasury obligations. As a matter of fact,  the average duration of this ETF is the lowest I have ever observed—even lower than money market accounts.

click to enlarge images

In the table below are details on these and two other short bond ETFs that are not shown in the graph: iShares Lehman Short Treasury Bond Fund (SHV) and Vanguard Short Term Bond ETF (BSV). The table shows some of the important characteristics of each ETF.

 

In compiling the data, I wanted to show the full range of short funds, from the ultrashort to longest average durations that are still classified as short. As you can see, a short bond can vary in average duration from a few days (USY) to two and a half years (BSV). You can also see the duration and the level of returns are tightly related: shorter durations mean lower returns and lower volatility; longer durations pay higher dividends and are more price volatile.

It was not too long ago that ETF investors had little choice on the duration or their short holdings, but there has been a healthy increase in the variety of these instruments over the last couple of years. Now, investors can specifically tailor their holdings to match their needs in the yield/volatility tradeoff that is so predictable with high quality fixed income products.

Although I mentioned that bond and bond funds are more attractive when equities are falling, a well balanced portfolio will always hold both fixed income and equity assets.  It is a mistake to rely on bonds only during hard times. You will likely buy them only after your heaviest equity losses are behind you, and you will then be stuck with an over-allocation of fixed income assets when the equity market begins recovering. Timing markets is not something I can do, and I don’t know anyone who can; there are many who say they can. In my view, the stability and consistent growth that bonds bring to investors are important even in periods when equities are prospering, so I recommend a consistent fixed asset allocation, changing only with the needs of the investor.

Bond ETFs are a reasonably efficient way of holding debt obligations, especially if you have a broker who offers free trades. You get the benefits of a constant average duration and reinvested dividends, and you can escape the hassle of maintaining a portfolio of direct bond ownership. However, if you are comfortable with buying individual bonds through a broker, and your costs are low, then buying and holding individual bonds is a good way to go. For years I have maintained a brokerage account with a broker for the sole purpose of using their no-fee purchasing of Treasury obligations. They offer free purchases, though,  only when you bid at the Treasury’s weekly auctions,  so it precludes secondary trading. If your broker charges for Treasury purchases at auction, it might pay to look for one who doesn’t.  Otherwise, bond ETFs are easy and efficient to trade if your transaction costs are zero or at least low. 

If you consider adding fixed income to your holdings, you will find there is no definitive answer as to how much of your portfolio should be in bonds or other fixed income instruments.  Indeed, if there is any agreement, it is that the precise amount of bond holdings should be tailored to each investor, depending on age, preferences for,  and needs to take risks. Usually,  I recommend at least 25% for younger investors, and as much as 75% for those who do not need to take significant equity risks. On this subject, you will likely find as many answers as there are advisors. 

In today’s market, I think staying short is the best bet. However, there are times when it will pay to stick your neck out the yield curve for a few more years. The higher volatility of intermediate-term obligations is partially offset by higher dividends, but finding the right balance for this trade-off is  unique with each individual. If you have a tolerance for risks, most of the time going out the yield curve has its rewards, but when interest rates rise,  intermediate bond prices will fall, and your portfolio will suffer.

Personally, I now hold more short-term ETFs, CDs, and short-term bonds than I have ever owned. This allocation reflects the extreme nature of today’s market. All durations beyond short-term, and all bond obligations other than Treasury issues or insured instruments are unpredictable and unstable. You might consider backing  off a notch in your quest for the highest possible return and put some short term bond assets in your portfolio. Bond ETFs make it easy to enter and exit the market, and you will probably sleep better with a more stable portfolio. You will definitely be better positioned to cope with market gyrations when they threaten your hard-earned assets.

Disclosure:  I own SHY and AGG.

Comments

[fjpenney:]

How easy it is to say after the fact that switching to short term bond etf's would have outperformed the S&P500. I use my own timing methods and my timer advised getting out of the market in mid-June. I can't say that I knew how bad the downturn was going to be.

Bear in mind that if you suggest overweighting in short bond etf's now, you must also advise when to go back to a normal bond weighting. How do you do that without engaging in timing which you say can't be done (or at least you don't know of anyone who can do it)?

2008 Oct 17 09:34 AM

[Ray Hendon:]

Good question. With my fixed income holdings, I use current market conditions to determine where new monies go. In a rising or unstable interest rate environemnt, I always go short. In a falling or stable interest rate environment I extend out to the intermediate range. I do not try and time the market. I simply go where I see the best spot at the moment. Fortunately, going from an average duratio of 2.5 to, say 4.5 is not exactly a techtonic shift in assets. And, in my view, one cannot be over or under-weighted in short or intermediate bond holdings. There isn't that much difference to justify any kind of attempted precision in allocation percentages.

For most of my fixed income portfolio, I keep my allocations fairly constant, but do vary the short-intermediate allocations slightly as market conditions change, but only to the extent that I am putting in new money.

In terms of "after the fact", I could say right now, that any time the equities market takes a major downturn, short fixed income investments will beat equities. This is not rocket science, but merely the simple observation that short bonds do not fluctuate much in price. I can also say with great precision exactly how much a bond fund will appreciate or depreciate given a 1% change in interest rates. This is not because I have any special predictive powers, but rather it is because the relationship between bond prices and interest rates is scientifically defined by the value of the funds' average duration.

Best wishes,

Ray

2008 Oct 17 10:13 AM

[whidbey:]

Why not money markets? Most of the funds you mention are not performing well, their yields notwithstanding. Just sitting in cash has not cost me money in my personal account and I can show you client accounts that have been badly hurt in IG, agency, treasury offerings. Even my GNMA accounts have been equal to or less than say, VG Prime Money Markets.

2008 Oct 17 11:34 AM

[Ray Hendon:]

I think money markets are fine, most of the time, but usually short bond ETFs and short bonds will outperform MMs. As you extend out the curve, to 2+ years AD, it is almost impossible for MM to keep up with the yield.

When you say that most of the funds mention are not performing well, how do you mean that? I see them as performing fine. If, by chance, you mean over a few days or weeks, then I can see that. But, if you will look at the average duration of a prospective fund, and measure the average duration against the length of time you can keep your money invested, then as long as the AD is as long as your investment horizon, you cannot lose money. The arithmetic of average duration will work that way.

I got out of MMs some time ago because of their returns were well below inflation. Now, however, almost all short durations obligations are below it, too. So, I try and at least keep as close to inflation as I can, and a longing short-term bond ETF is the best bet, at least as far as I can see.

Best wishes,

Ray

2008 Oct 17 01:10 PM

[bigmoney:]

Capital One is currently offering a Savings Account at 3.55, vs. the 2.87 for SHV. And I don't think 3.55 is the best of breed either. However, ETFs are definitely more convenient. I checked Ameritrade, which offers bonds and bond ladders, and the rates are not competitive with the best listed on bankrate. But again, its convenient.

2008 Oct 17 04:53 PM

[Ray Hendon:]

If short interest rates go down further, which some are predicting, then you will get a little price bump of SHV or SHY--less so on BIL or USY.

You must forgive me if I tend to write as if all accounts were like mine, were almost everything is in a tax protected account. The disavdanatage is that you don't have the freedom to move your money around into and out of savings accounts.

This is one of the oddest periods, financially, that I have every experienced. So much of what we expect is not relevant today. But, I think more normal times will return once the dust settles on the banking and credit crisis we have experienced.

Thanks for the comment.

Ray

2008 Oct 17 05:38 PM

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May 24 11:30 AM