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When the Fed implemented their near Zero Interest Rate Policy in the wake of the 2007-2008 financial crisis, short term rates took a nose dive (see chart below). Now that the taper deadline has been extended, it's fairly safe to say short term rates have stabilized. With Fed Chairman appointee Yellen expected to prolong the low rate culture, it's time to get used to a measly 0.35% return for a 2-year Treasury.


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If you've had short term (1-3 yr) bonds in your portfolio throughout the crisis and following years you probably cheered the plunge towards zero-interest rates. The following chart shows the running annual yield of iShares 1-3 Year Treasury Bond ETF (NYSEARCA:SHY) and PIMCO's relative newcomer (NYSEARCA:TUZ) since 2007:


(Click to enlarge)

Notice in periods of falling rates the yields on these funds trail the prevailing interest rates by ~1 year. That's good for bond holders, but now for the bad news. As I explained this article, bond prices are invariable tied to interest rates in a phenomenon known as bond convexity. Most investors know this as interest rate risk. That is, when these short term treasury rates inevitably go up, bond prices and returns go down. Since both SHY and TUZ rebalance according to their index, whenever Yellen decides it's time to taper these funds will be selling at capital losses to purchase higher yields.

So, how bad is bad? The bump in rates this May gave us some insight on what to expect for short-term Treasury ETFs going forward. Since rates bottomed back in August 2011, enough time has passed that our ETFs have repositioned with nearly all post rate-bottom bonds. If we correlate the annual change in the two year rate with the total yield on the ETFs since May we get the chart below:


(Click to enlarge)

Ouch! Should rates rise from their present 0.35% to even a meager 0.61% (a change of 75%) bond ETFs could yield a whopping 0.0% before taxes. If you've allocated anything to short-term treasuries in the last 3 years this is your future; a maximum of 0.35% APY with the near guaranteed potential for worse. Even a pre-teen with a spending problem will tell you that's a bad purchase. Now is the time to rethink your bond allocation.

Assuming your short-term Treasury block was designated as the lowest risk asset in your portfolio with liquidity, we'll need to keep it that way. Equities, longer term bonds, REITs, MLPs, and basically anything that could be summed up with "etc" are all out of the question. The soundest Seeking Alpha advice when all else is too risky is to "stay at cash", but that could be many things.

You could buy the actual bonds and hold them until they expire (navigating TreasuryDirect.gov isn't worth the 0.35%) but your money's out for at least a year. CDs are equally as illiquid, T-bills less so, but even money market and savings accounts will have transaction restrictions. Not much is left, but if your financial institution is like mine you might have noticed in all this rate crashing that your savings account is probably yielding the same as your checking. Believe it or not, the national average checking account interest rate is 0.49%.

That's right, most checking accounts in the US and online are actually yielding higher than the current 2-year Treasury with none of the associated interest-rate risk. In fact, as you probably know, checking accounts are even FDIC insured up to $250,000 against loss of principal. Not to mention most institutions adjust their rates to stay competitive (think floating rate), and you can pull your 'principal' out at anytime, anywhere (i.e. an ATM), with no rate penalty.

Obviously if your bond allocation is held in a 401(k) or IRA you probably won't have the option to withdraw into checking. Nor do you probably have a large selection of bond options. In those cases you might just have to ride out a rise in rates, but the convexity loss (as seen above) will be small.

If you're holding any of the popular "composite" bond funds like iShares Core Total Aggregate U.S. Bond ETF (NYSEARCA:AGG) or Vanguard's Total Bond Market ETF (NYSEARCA:BND) just be mindful short-term issues might make up almost 28% of your portfolio. Not that it's adverse, actively managed funds like PIMCO's Total Return ETF (NYSEARCA:BOND) often shorten their holdings when they expect rates to rise; but again, why pay somebody else's expense ratio when your checking account gives you the same yield.

Conclusion

Ultra low short-term rates are here to stay, at least for the life of any respective issue. One to three year bond funds like SHY now provide extensive exposure to the poorest yielding holdings in their history coupled with maximum potential for interest-rate risk. Investors looking for a safer, steadier alternative to balance out their portfolio need look no further than their own checking account. They yield the same or better, and they offer plenty of benefits bonds don't. It's a strange telling of the times when your bank might actually be on your side, but that's reality.

Source: Still Holding Short-Term Treasuries? Lose The Risk And Choose This Instead