Short-Term Bond ETFs to 'Play It Safe'

by: IndexUniverse

(Editor's Note: The following is an edited excerpt of an article from February's edition of the Exchange-Traded Funds Report. Subscribers can read the full story here.)

As markets continue to slide, many advisers are suggesting that investors play it safe. In the world of fixed-income, that means staying on the short side of the duration curve to avoid the threat of rising interest rates.

In the past 18 months, as the world's credit crisis has spread to stocks, a number of options have come to market for exchange-traded fund investors. Those looking for short-term bond ETFs can now find several different portfolios to choose from.

Most of them, however, don't have much more than a year of trading under their belts. It means there's not a lot of trading history on the funds. Still, we can evaluate those funds to see where frightened investors might best park their cash.

Treasury Bond ETFs

The "granddaddy" of the short-term bond ETFs comes-no surprise-from Barclays Global Investors. The iShares Barclays 1-3 Year Treasury Bond Fund (NYSEARCA:SHY) dates back to July 2002, and had $7.69 billion in assets at the end of 2008. For all intents and purposes, its portfolio consists entirely of Treasury notes. It had more than 40 holdings as of year-end 2008. According to iShares, SHY had an average weighted maturity of 1.82 years.

The fund was the second-best performer in the group in 2008, up 6.61%. It had 3-year and 5-year annualized returns of 4.78% and 3.94%, respectively. SHY charges an annual expense ratio of 0.15%.

Another iShares fund is also a heavy hitter in the group and holds bonds with even shorter maturities. The iShares Barclays Short Treasury Bond Fund (NYSEARCA:SHV) had about $1.57 billion in assets at the end of 2008. Created in early 2007, it was up 2.84% in 2008. It holds 13 different Treasury notes and has a weighted average maturity of just 0.39 years. Its components have durations ranging from just one month to a year. The fund charges 0.15% in management fees.

The SPDR Barclays Capital 1-3 Month T-Bill ETF (NYSEARCA:BIL) holds bonds with maturities ranging from one to three months. Its average maturity is just 0.14 years. This extremely short-term bond fund has just 10 holdings (all Treasury bills). BIL ended 2008 up 1.53%, with $743 million in assets. The fund charges 0.13%, making it one of the cheapest ETFs in this comparison. If you want safe, you've got it with BIL.

Diversified Short-Term Bond Index ETFs

Of course, if you're willing to diversify away from Treasuries, you can take on short-term corporate debt and perhaps look for a bit more yield. Right now, because of concerns about the short-term market, you get a lot more yield.

The largest fund in this category is offered by Vanguard. The Vanguard Short-Term Bond ETF (NYSEARCA:BSV) is the ETF share class of a much larger fund, with more than $9 billion in assets, of which BSV represents about $1 billion. The fund tracks the Barclays Capital U.S. 1-5 Year Government/Credit Bond Index. It holds a mixture of government, corporate and international dollar-denominated debt. The index has almost 2,000 components, but BSV only holds about half of that number. Government or agency debt represents nearly 70% of the portfolio.

The fund has an average maturity of 2.8 years and typically a significant jump in yield from the Treasury ETFs. BSV is the cheapest of the funds in this comparison, with an expense ratio of just 0.11%.

The iShares Barclays 1-3 Year Credit Bond Fund (NYSEARCA:CSJ-OLD) is a pure-play on short-term corporate debt, avoiding Treasuries altogether. The fund ended 2008 with about $793 million in assets. Last year it rose 3.85%. The portfolio is dominated by corporate debt from the Financial (33%) and Industrial (32%) sectors, as well as non-corporate debt (27%). While the underlying index includes 581 components, the fund is optimized, with fewer than 120 holdings. CSJ has an average maturity of 1.95 years and usually reflects the higher yields available in the corporate market. The fund charges 0.20%.

The Claymore U.S. Capital Markets Micro-Term Fixed Income ETF (ULQ) is one of the newest funds in this group, launched in February 2008. It tracks the Capital Markets Liquidity Index, which covers money market and micro-term fixed-income securities. These are ultra-short-term corporate debt which, before the financial crisis, was considered some of the safest paper on the market. The underlying index has an average maturity of 0.24 year and includes 36 components from a mix of sources, including corporate and government debt.

ULQ ended 2008 with about $6 million in assets. It charges 0.27% in annual expenses, making it one of the most expensive ETFs in this survey.

Actively Managed ETFs

Some believe that the opaque credit markets lend themselves to active management, where savvy buying and credit-picking can improve returns. Two of the ETFs in the short-term bonds category are actively managed and were introduced in 2008.

The WisdomTree U.S. Current Income ETF (USY) is the larger of the two, with about $21 million in assets at year-end. It invests primarily in very short-term, investment-grade debt.

WisdomTree does not label it as a money market fund, and it is not insured by the FDIC, as true money market funds are at this point. Still, many consider it to be effectively a money market fund. Its largest component is a federal home loan discount note that represents roughly 35% of the portfolio. The fund charges 0.25% in annual expenses.

The PowerShares Active Low Duration Fund (NYSEARCA:PLK) is the smallest fund in the group, with just about $3 million in assets at the end of 2008. Its portfolio consists mainly of U.S. government, corporate and agency debt, with roughly 96% of the portfolio invested in securities with maturities of five years or less. The portfolio currently includes 21 holdings.

In addition to being the smallest fund in the group, it is also the most expensive, charging 0.29%. Expanding out the yield curve, however, it tends to pay higher interest rates.