Spiking Short Term Bond ETF Assets May Stick

Driven by rising interest rates, 2018 flows into short-term ETFs have been prolific.

Year-to-date, these ETFs have gathered more than $43 billion in assets. This number represents close to 58.4% of the total inflows into fixed-income ETFs for the year.

Flows into fixed-income ETFs at 11/21/2018; data from FactSet

The yield-curve dynamics have made short-term debt attractive on a relative basis to longer-dated debts. The question now is whether the short-term ETF popularity will stick into 2019.

Short End Of Curve Trade

Short-term rate popularity is mostly due to changes in the yield curve.

During 2018, rates have experienced an upward shift, as displayed in the chart below. Particularly, rates at the front end of the curve (short maturities) have almost doubled, thus giving investors better incentives to park their money in short-term debt.

Treasury Yield Curve; data from the U.S. Department of the Treasury

However, higher short-term rates are not the only benefit for this type of trade; shorter maturity bonds also help mitigate investors’ reinvestment risk and duration risk.

Imagine an investor rolling a bond every three months during the year, and as each rollover date arrives, the interest rate increases. So, why would the investor allocate money into a longer time frame, increasing the uncertainty, if a short-term maturity instrument offers an enticing yield alongside expectations of higher yields in the future?

In the case of a short-duration Treasury ETF, the investor would receive higher dividend payments each month as the fund rolls over its exposure. And because of the short maturity, the price of the ETF would not decrease as much longer-maturity ETFs would.

This can be seen in the total return of the iShares 1-3 Year Treasury Bond ETF (SHY) with a gain of 0.56% so far in 2018, compared to a loss of 7.36% in the iShares 20+ Year Treasury Bond ETF (TLT).

Will Demand Continue?

Three factors would play an important role for the demand for short-term debt ETFs: the Fed, the yield curve and stock market volatility. Let’s look at each.

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]