Why Short Term Bond ETFs Are Better

Todd Rosenbluth is director of ETF and mutual fund research at CFRA.

With the U.S. equity markets correcting, it should be little surprise that investors pulled $22 billion out of related ETFs in the week ended Feb. 8, while adding $1.6 billion to U.S. fixed-income ETFs, according to ETF.com.

But due to the impact of rising interest rates, some of the more popular fixed-income ETFs generated negative total returns to start 2018.

The iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), with $34 billion in assets, has been around since 2002, and for many, is the go-to-vehicle for investment-grade exposure. This is in part because of its relatively strong liquidity and its modest 0.15% expense ratio.

However, LQD was down 2.2% year-to-date through Feb. 9. Meanwhile, the SPDR Bloomberg Barclays High Yield Bond ETF (JNK), which came to market in 2007 and has $9 billion in assets, focuses on bonds rated BB or below. JNK has a 0.40% expense ratio and also stands out to CFRA for its ample liquidity. Yet JNK was down 1.4% to start 2018.

Rising Rates An Uphill Battle

Both LQD and JNK are being hampered by the negative impact of rising interest rates. For example, the yield on the 10-year Treasury bond climbed more than 0.40% to just under 2.9% on Wednesday, and other bonds experienced higher yields.

As rates rise, the value of bonds inside a portfolio can decline to a certain degree. To measure the downside potential, CFRA and others use duration, a metric that reveals the sensitivity of rising or falling rates. In rating more than 240 fixed-income ETFs, we include duration, credit quality and yield as a three-legged stool. The greater the interest rate or credit risk an ETF takes on, the higher the expected return.

LQD has an average duration of 8.4 years. For investors wanting similar credit exposure as LQD, but with less interest rate risk, iShares offers a strong product in the iShares 0-5 Year Investment Grade Corporate Bond ETF (SLQD). SLQD has an average duration of just 2.3 years and charges an even lower expense ratio than LQD (0.06% vs. 0.15%).

At the end of January, SLQD had 42% of its $740 million in assets in bonds rated A or equivalent by major rating agencies and 40% rated BBB. Naturally, a smaller ETF like SLQD trades less frequently than LQD, but SLQD’s bid/ask spread was relatively tight, at $0.02. Year-to-date through Feb. 9, SLQD lost just 0.34%, a narrower decline than its iShares sibling.

Source: MarketScope Advisor, Jan. 31, 2018

Same Story With Junk Bond ETFs

To start 2018, investors in a younger, short-term version of JNK would have also fared better than the original. JNK has an average duration of 3.8 years, which is narrower than investment-grade bonds products as investors incur greater credit risk than duration risk.

However, the SPDR Bloomberg Barclays Short-Term High Yield Bond ETF (SJNK), which launched in 2012, provides similar credit exposure as JNK (39% of its $4 billion of assets in bonds rated BB and B), but with duration of just 2.2 years.

The lower interest rate risk helped to limit the downside in recent weeks. SJNK’s total return was only down 0.32%. SJNK also trades less frequently than its longer-term peer, but has a tight $0.01 bid/ask spread to go along with its 0.40% expense ratio.

Rate Hedged Funds Also An Option

In addition to SHYG and SJNK, investors wanting to protect against rising interest rates can use interest-rate-hedged ETFs. These products have duration of close to zero as they hedge out the impact of rising rates, but also limited asset bases currently.

The iShares Interest Rate Hedged Corporate Bond ETF (LQDH), the ProShares High Yield-Interest Rate Hedged (HYHG) and the Xtrackers Investment Grade Bond Interest Rate Hedged ETF (IGIH) are some examples.

All three generated positive total returns thus far in 2018. Of course, rates could narrow, as they have in the past, and investors using interest rate hedges could also be giving up some upside potential.

At the time of writing, neither the author nor his firm held any of the securities mentioned. Todd Rosenbluth is director of ETF and mutual fund research at CFRA, an independent research firm that acquired S&P Global Market Intelligence's equity and fund business in October 2016. He can be reached at [email protected]. Follow him on Twitter @ToddCFRA.