Spiking Short Term Bond ETF Assets May Stick

November 27, 2018

The Fed

The main driver for short-duration ETF demand will be the Federal Reserve’s decisions.

If the Fed keeps raising short-term rates as it did during 2018, investors would have the same underlying incentive to allocate money into short-duration ETFs. As of the end of November 2018, market expectations are that the Fed will hike rates one more time on Dec. 19. Still, the outlook for 2019 remains uncertain, with divided agreement between market participants on whether the Fed will implement two or three additional rate hikes during the period.

Flattening Yield Curve

The yield curve is not as steep as it was at the beginning of the year. While the curve is not flat, longer maturity rates have not increased at the same pace as short-term rates. For fixed-income ETF investors, this means larger time frames may have lower-duration risk and ETF prices may not go much lower.

Furthermore, if short-term rates stop going up and inflation expectations are tempered, long-term debt prospects improve.

In this scenario, the yield curve would flatten, and long-term debt prices may remain stable and give traders flexibility to profit in case short-term rates start declining. Thus, short-term ETFs may continue seeing flows, but will face competition from longer-dated ETFs, such as TLT, as they become competitive.

Stock Market Volatility

The recent market rout has heightened the demand of short-duration ETFs, as a safer instrument with fewer chances of downside surprises.

During the last-trailing 30 days, when the S&P 500 had a negative 4.06% total return, ultra-short-term and short-term ETFs had an average return of 0.38%.

As shown in the table above, traders have favored these short-term Treasuries, with total inflows of around $10 billion.

Furthermore, currently, short-term rates offer an attractive yield compared to stocks. The S&P 500 Index's trailing last 12 months' dividend yield is around 1.97%, while the one-year Treasury yield is paying above 2.67%.

So, conservative investors may continue to drive short-duration ETF demand as long as their yields are high compared to a challenging risk/reward stock market environment.

Luis Guerra can be reached at [email protected]

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