Sector: Fixed Income
iShares Barclays 1-3 Year Credit Bond Fund (NYSEARCA:CSJ)
Rising interest rates are presently one of the most discussed investment risks. The market risk of long-term bonds can be hazardous to a portfolio if Treasury yields increase by a meaningful amount. Regardless, the present state of money market yields – which are near zero - have forced investors further along the yield curve to obtain income. Treasury bonds intuitively make sense as a safe investment to bolster yield but the duration component of these bonds can potentially be hazardous to your portfolio’s health. We examine several fixed income ETFs that can augment the yield of a portfolio in a two-step process 1) basic yield enhancement or 2) implementing a tactical fixed income short position.
Mainstream economists forecast a 50 basis point increase in the 10-year Treasury yield by the end of 2010, and another 50 basis point rise by the second half of 2011. While economic forecasts do not always pan out, this type of risk is worth reviewing in a portfolio context. The following table has five different fixed income ETFs:
The absolute yields on TLT and LQD are attractive. Both offer over 4.0% more yield than a money market fund. The 20+ Year Treasury fund is backed by the full faith and credit of the US Treasury, and the Investment Grade Corporate Bond fund contains credits from highly rated companies. However, the duration risk on each fund can expose a portfolio to a significant decline in value if interest rates were to materialize.
For a $100,000 investment, two of the Treasury funds could experience a market value decline in excess of their annual yield under a 50 basis point rate increase. The corporate credit funds, LQD and CSJ, offer less market value decline relative to a years worth of income under a 50 basis point increase in rates. The iShares Barclays 1-3 Year Credit ETF is not a money market fund because of its 1.87-year duration, but it is a credible low duration fund for a couple reasons. First, its annual income is 1.5% higher than the Treasury fund of similar duration. Second, the risk of downward price performance due to increased interest rates is lower for CSJ than LQD. Third, there are options traded on CSJ. Call options struck ½ point out of the money can enhance the annualized equivalent yield on this ETF to 3.48%. Thus, CSJ helps to solve the strategic portfolio decision of: 1) yield enhancement, and 2) implementing the tactical short position.
There are two ways to construct the short duration position in the portfolio. One alternative is to acquire CSJ and wait for higher yields then buy a long duration fund. A more aggressive strategy acquires CSJ along with short positions in the Treasury funds, and this approach offers more leverage to higher interest rates.
iShares Barclays 1-3 Year Credit Bond Fund
- CSJ recently traded at $104.44, and it has a current payout ratio (dividend/price) of 2.66%. It seeks investment results that correspond to the Barclays Capital U.S. 1-3 Year Credit Bond Index. The price volatility of CSJ is low, and management fees are 0.20%.
- Strategy: Acquire 1,000 shares of CSJ as a short duration bond fund in order to avoid the interest rate risk of a long duration bond fund. Alternatively, initiate the more aggressive strategy with CSJ, and buy one put on each of TLT, IEF, and SHY. Strike the puts relative to each ETF at $86, $88, and $83, expiring in September 2010. These strike prices are roughly 25 basis points out of the money – if Treasury yields rise 25 basis points then the put options are in the money – and the net cost of the 3 put options is $425 to control $26,307 worth of the three underlying ETFs. Acquiring the puts as a one time investment it will reduce the yield of the position to 2.26% ($2,781 - $425 / $104,440), or on an annualized basis the yield is 1.69% ($2,781 - $425 X 2.5 / $104,440). In either scenario, the yield is higher than the 1.15% yield offered on the short-term Treasury ETF (NYSEARCA:SHY) that has the same duration as CSJ.
- Risks: 1) CSJ is not a money market fund and it contains interest rate and credit risk, 2) there is an options market on CSJ but it is illiquid and the put and call contracts have little volume.
Disclosure: Author holds a long position in CSJ