Stepping Off The Sidelines With Fixed Income ETFs

Includes: CSJ, FLOT, LQD, SHV, SHY
by: Matt Tucker, CFA

A few weeks ago, my colleague Russ blogged about the preference skittish investors are showing for cash. Given the volatile market conditions and uncertain political environment, it’s understandable that investors are finding comfort in cash.

But Russ gave three reasons why moving to cash might be a mistake, and he said it is worth considering keeping some equity exposure. I agree with Russ that staying on the sidelines could be a mistake, and I would emphasize that for investors looking to reduce portfolio risk there are a number of fixed income ETF solutions available.

For investors who crave the comfort of cash, short duration vehicles could be a good way to dip your toes into the fixed income market. Here are three reasons why:

1. No long-term commitment

Fixed income ETFs trade throughout the day on a stock exchange, giving you flexibility and the ability to nimbly adjust your exposure. Say, for instance, you become concerned about risk. You can sell a risky asset class and access a fixed income ETF intra-day. If the market changes, you can then sell the ETF and re-deploy your proceeds.

2. Potential for higher yields than money market funds

iMoneynet reports that the 30-day average yield on money market funds as of November 8 is 2 basis points. Investors who do not seek a stable net asset value and who are looking for higher yields may find fixed income ETFs to be an interesting option. For investors who want to keep interest rate risk low, but who are comfortable taking on some credit risk, the iShares Floating Rate Note Fund (NYSEARCA:FLOT) offers investors a 30-day SEC yield of 1.45% as of November 10 with a duration (a measure of interest rate sensitivity) of only 0.14 years. For investors comfortable taking on a low level of both interest rate and credit risk, the iShares Barclays 1-3 Year Credit Bond Fund (NYSEARCA:CSJ) has a 30-day SEC yield of 1.42% as of November 10 with a duration of 1.85 years. There are also lower risk options like the iShares Barclays Short Treasury Bond Fund (NYSEARCA:SHV) that has a 30-day SEC yield of 0.04% as of November 10 but that invests solely in U.S. Treasury securities. (Past performance does not guarantee future results. For standardized fund performance, please click on the following tickers: FLOT, CSJ, SHV.)

The key is that an investor has the control to select exactly the exposures they want, and, by extension, avoid the exposures they don’t want.

3. Less volatile than longer-term funds if interest rates rise rapidly

Short-duration investments will have lower interest rate sensitivity than longer-term funds. For example, the 0.12 year duration of FLOT means that we can generally expect FLOT’s price to decline by 0.12% if interest rates rise by 1%. By comparison the iBoxx $ Investment Grade Corporate Bond Fund (NYSEARCA:LQD) has a duration of 7.51, meaning that we could generally expect its price to decline 7.51% if interest rates rose by 1%. (Potential iShares solutions: FLOT, SHY or CSJ.)

The bottom line is that investors who are looking for yields above those provided by money market funds have a range of options to choose from. Just keep in mind that yield isn’t free - it always comes along with some type of extra risk. By understanding what risks you are willing to take and constructing a short duration portfolio appropriately, an investor can design a wide range of potentially higher yielding alternatives to traditional cash vehicles.

Disclosure: Author is long FLOT and SHV.

Source: Bloomberg

The performance quoted represents past performance and does not guarantee future results. Investment return and principal value of an investment will fluctuate so that an investor’s shares, when sold or redeemed, may be worth more or less than the original cost. Current performance may be lower or higher than the performance quoted.

An investment in fixed income funds is not equivalent to and involves risks not associated with an investment in cash or money market funds.

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