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Short Looks Beautiful to Bond Investors

Some ETF buyers are shifting into funds that may suffer less if rates keep climbing

As interest rates spiked in the second quarter, many investors in exchange-traded funds changed horses: from intermediate or long-term bonds to bonds with shorter maturities.

That shift may accelerate in coming months as the Federal Reserve follows through on recent statements that indicate plans to start scaling back its massive bond purchases, which have kept fixed-income yields at depressed levels for years. When rates rise, bond prices fall, especially those with longer durations, which in turn hurts investors in funds holding such bonds.

However, investors looking for higher yields, less volatility, or both had better understand that, despite numerous ETF options for shorter-term fixed-income products, there are some stark trade-offs. You can take on a little less risk, or you can earn a little higher yield. But you can't do both.

John Weber

Going to shorter maturities typically lowers yield. If you find a fund that invests in bonds maturing soon but doesn't require you to take a lower yield, chances are "you're just magnifying other flavors of risk," says Todd Rosenbluth, director of ETF research for S&P Capital IQ.

"Yield is never free," says Matt Tucker, head of fixed-income strategy for ETF sponsor iShares, a unit of BlackRock Inc. "You need to understand what risks a fund is taking to generate yield." Those risks, Mr. Tucker says, can be calculated by looking at the currencies of the bond denominations, what sectors are most heavily represented, and the average credit ratings of the holdings. Such statistics are generally found on the website of the fund sponsor, or through online services such as fund research firm Morningstar Inc., ETF Database or XTF Inc.

For the Duration

To understand a fund's sensitivity to rate changes in detail, you also have to look for a figure known as duration. A bond fund usually calculates the weighted average duration of the bonds it holds. Measured in years, duration reveals the expected change in the price of a bond (or bond fund) due to a change in interest rates. For a fund with a duration of 5, for example, a one-percentage point rise in rates would lower the price by 5%. A one-point decline would boost the price by 5%.

The yield on 10-year Treasurys jumped in the second quarter to 2.48% from an early-May low of 1.63%, as it became clearer the Fed is getting ready to ease up on its bond purchases. Intermediate bond funds returned negative 2.7% for the quarter, according to Thomson Reuters Corp.'s Lipper unit.

In the rush to short-term bonds, 32 unleveraged short-term fixed-income ETFs collected $17.55 billion in net flows since December, XTF says. The most popular: Vanguard Short Term Bond ETF, with a weighted average yield to maturity of 0.63%, XTF says.

Among funds with the shortest durations are those that hold floating-rate bank loans to businesses. These securities tend to have maturities of five to 10 years but interest rates that reset monthly or quarterly based on a spread above a market benchmark, hence their inclusion among short-term options.

The largest floating-rate ETF, PowerShares Senior Loan Portfolio, has grown to $4.6 billion since its March 2011 inception and has a yield to maturity of 5.41%. The underlying loans, on average, reset every 18 days. The floating-rate category also includes the most successful ETF launch so far in 2013, the $291 million SPDR Blackstone/GSO Senior Loan ETF. This actively managed fund currently yields 2.32% with a reset, on average, every 49 days, according to fund sponsor State Street Global Advisors.

The key risk with the floating-rate funds: The borrowers are typically less creditworthy.

"This asset class was absolutely crushed during the financial crisis and is not a safe haven," says Adam Thurgood of HighTower Las Vegas, which manages $500 million in client assets.

Investors who want at least a little return—more than a money-market fund pays—might consider funds whose holdings are just outside the stringent regulatory requirements for money-market funds. This group includes Pimco Enhanced Short Maturity Strategy, Newfleet Multi-Sector Income ETF and FlexShares Ready Access Variable Income.

With the Securities and Exchange Commission proposing new rules on how institutional money-market funds operate, including requiring net asset values to float, these funds offer a little more yield in return for being allowed to sometimes drop below the formerly fixed $1 net asset value.

Target Maturity

Another option: ETFs that generally buy only debt maturing in a particular year. Two fund sponsors currently offer these fixed-maturity ETFs, which are tailored for investors who want their bond funds to be, amazingly, bond-like. Guggenheim Investments offers investment-grade and high-yield corporate ETFs. Guggenheim BulletShares 2016 Corporate Bond, which holds bonds that mature in 2016, has a weighted average yield to maturity of 1.31%, according to XTF. While Guggenheim's investment-grade offerings are heavy in financial services, iShares has ETFs that exclude bonds from the financial sector. Its iSharesBond 2016 Corporate Ex-Financials Term ETF has an average yield to maturity of 1.08%, and counts among its top holdings Cisco Systems, Home Depot and Novartis.

Says Mr. Thurgood, "Fixed-maturity ETFs will see increased demand in the years to come as rates rise and duration management becomes critically important to prevent loss."


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