These are good times for ETF bond investors.  For years the ETF market offered long and intermediate-term bond funds with just a few short-term and no ultrashorts or money market funds.  Within the last few years, however, there has been an awakening in the industry.  Many vendors are now expanding their offerings of short-term holdings. 

The importance of short-term holdings in one's fixed income portfolio is not to be underrated.  For a balanced portfolio, a fairly common allocation would allocate about 1/3 each to: (1) inflation-protected instruments, (2) intermediate-term and (3) short to ultrashort holdings.  Although there is no definitive answer as to how to allocate fixed income, equal weighting among the three I noted is an easy-to-implement strategy.  Of course, opinions vary widely.

Regardless of your allocation, however, it is important to be flexible with short-term holdings.  A variety of short and ultrashort options allows an investor to shift monies around, depending on the best yields and desired stability.  The more options, the better, especially in times of low interest rates.  In the past, you simply could not use ETFs for these types of activities. 

The grandfather of short bond ETFs is iShares’ Lehman 1-3 Year Treasury Bond Fund (SHY), dating from July, 2002, with current assets under management of over $9 billion.  With an average duration [AD]  of 1.64 years, it is far from an ultrashort in duration.  About five years later, in January of 2007, iShares followed up with Lehman Short Treasury Bond Fund (SHV), an ultrashort ETF with an AD of  0.31.  This helped, but the duration was still two to three times longer than a typical money market instrument.

On May 25 of 2007, SSgA finally broke the 90-day duration barrier with their ETF, Lehman 1-3 Month T-Bill (BIL), with an AD of 0.15.  Its asset base quickly expanded  from $82 million by August of last year to $220 million at the end of April, 2008.  Three new products in the ultrashort range of durations were introduced in the first half of 2008.    Table 1, below, summarizes the current ETFs with an average duration of below one year:

Claymore’s U.S. Capital Markets Micro-Term Fixed Income ETF (ULQ)  began selling in early February of this year, but it has not garnered much of a market.  It seemed an odd choice, to me, to go head to head with the huge iShares Lehman Short Treasury Bond Fund (SHV) with almost a billion dollars in assets under management.   But, I am not privy to Claymore’s thinking about its product.  A major factor in their choice was probably that it was a part of its Capital Markets ETF that included bonds and equity holdings.  Claymore simply broke out the short-term bond holdings of that fund to make a separate entry.  Certainly this was cheaper than starting from scratch.   Its trading has been thin.

The Bear Stearns offering of its Current Yield Fund (YYY) is a study in bad luck.  About the time of its introduction, Bear Stearns (BSC) saw its stock price fall from the penthouse to the distressed bargain basement because of its involvement in sub-prime paper.  Couple this near bankruptcy (being bailed out by the Federal Reserve in a shotgun marriage to Morgan Stanley (MS)), with the fact that it had chosen the ETN structure for its new baby, and you get a disaster in the making.  Since ETNs depend on the good credit rating of the provider, the collapse of Bear Stearns’ credit rating, which forced its merger, was not good news for investors.  It goes days (if not weeks) without trading.  I don’t know what to expect from this ETN, although it was capitalized at $50 million (huge by comparison with most new offerings).  But its duration of 225 days puts it at the high end of an ultrashort fund and below the low end of a short-term fund.  It seems an odd duck, to me. 

Lastly, about a week ago, Wisdom Tree brought out its U.S. Current Income Fund (USY) with an even lower AD than BIL.  Its reception has been good, with fairly brisk trading in its first few days of life.  This ETF is fairly straightforward as an ultrashort instrument, but it is being positioned as a currency fund.  True, it is denominated in dollars, and it trades in dollars, while Wisdom Tree's other new currency offerings hold foreign currencies or futures contracts in foreign denominations.   While most providers would simply call it an ultrashort bond ETF, it is a currency fund; it’s just that the currency is U.S. dollars.

Aside from the good news that ultrashort funds are more plentiful, there are some clouds on the horizon of the bond fund world.  The fear of inflation coupled with a sagging economy has put the Federal Reserve Open Market Committee in Neverland—it can’t lower interest rates because of the threat of inflation, and it can’t raise them because of the threat of a slowing economy.  But, the signals are for higher interest rates, when the committee feels conditions warrant, so bond prices of most durations are expected to fall in the months ahead. 

This outlook is not necessarily bad for the ultrashort ETF holder.  Since their duration is so low, interest rate changes have little effect on their NAV.  If interest rates rise over the coming months, ultrashort funds, whose portfolios completely turn over within 90 days, will quickly adjust to rising interest rates.  This will keep investors happy with fairly steady net asset values and rising yields.

The best ways to demonstrate this feature of ultrashorts is to look at three different average d,uration funds graphed over the same period.  Chart 1, below shows three bond ETF over a one year period. The three ETFs are: Vanguard’s Total Bond Market (BND), an intermediate-term ETF that follows the Lehman Aggregate Bond Index and has an AD of 4.4 years,  Vanguard’s Short-Term ETF (BSV), with an AD of 2.5 years, and SSgA’s Lehman 1-3 Month T-Bill ETF (BIL), with an AD of 0.11. 

I regret having to use BSV rather than iShares’ counterparts SHY,  but I wanted to show total returns of the three different duration ETFs in Chart 2, and Microsoft’s Money site is the only one I know that does it.  Unfortunately,  the database of Microsoft’s site does not include all of the iShares ETF products.  However, there is almost no difference in the behavior of the comparable ETFs, and the principle is well demonstrated with the ETFs shown in both charts.

Chart 1 is a price chart, not a total return chart, so you can’t tell how much these instruments would have appreciated over the year.   But, the stability of a lower AD is easily seen.  The ultrashort BIL barely moves during the year, at least when compared with its longer-duration brethren.  Although the yields of ultrashort are low, the owner does not have to be concerned with a total return loss.  It is this feature that attracts many.  As a temporary holding ground when interest rates are falling or rising, they promise stability.

Chart 2 is a total return chart of a $10,000 investment, where dividends of each ETF are reinvested monthly. The same ETFs are shown: yellow for BSV, blue for BIL and black for BND.

The last year is quite unusual in the bond market when a short-term instrument (BSV) matches the total return of an intermediate fund (BND).  It  is unusual because of the falling interest rate environment during most of the period, at least for short bonds, followed by a leveling off and slight rise in the last few months.  Nevertheless, the higher volatility of BND, with its relatively high AD is easily seen, especially since February, where the short ETF (BSV) was much more stable.  The ultrashort BIL, over the same last months was rock solid. 

Over the long run, however, an intermediate-term ETF will have a higher expected total return than its short or ultrashort cousins.  In the constant tension between higher returns and stability, it’s good to have all three types of instruments in your portfolio.  It helps ride out the different storms that affect the fixed income market at various times.

I am happy to see better selections of short and ultrashort ETFs.  I wouldn’t be surprised  to see a money market ETF out sometime within the next year.  More selections allow investors more flexibility in trimming their portfolios during changing economic conditions. 

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Ray Hendon

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