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A Tactical Tool For Dialing Down Fixed-Income Risk

This ETF is light on interest-rate risk and light on credit risk.

John Gabriel, 05/29/2015

One of the most popular ways that investors have been preparing is by shifting toward the short-end of the yield curve. Shortening the average duration of a fixed-income portfolio can certainly be an effective way to limit the potential price impact from rising interest rates. However, there are some nuances to consider before piling into the short-end of the yield curve. As Morningstar analyst Thomas Boccellari noted in a recent article, interest-rate changes are rarely linear.

Those who place higher priority on preserving principal, or limiting price impact, can still find utility in short-term bond funds. For example, investors can look to iShares 1-3 Year Treasury Bond SHY for exposure to a portfolio of short-term Treasury bonds with an average duration around 1.8 years. The bonds are backed by the U.S. government, which means that the risk of default is near zero. Given the short duration and low yields, the fund can be viewed as a substitute for a cash account.

Bond prices have an inverse relationship to interest rates. If interest rates go up, bond prices go down. There have been very few sustained periods of rising interest rates during the past 30 years. Investors today are rightly concerned that rates will rise in the future. SHY's portfolio has an average duration of about 1.8 years. According to the basic rule of thumb, this means that if interest rates rise 1%, then the value of SHY's portfolio will decline by about 1.8%. Remember, though, that this is just a rough approximation.

This fund's current SEC yield is comparable to what you might currently get from a three- to six-month CD from your local bank, but, unlike CDs, there are no early withdrawal penalties. The fund also will not offer the principal and interest-rate guarantees of a CD. Another thing for investors to consider is the transaction costs involved with moving in and out of this fund. Given the very low expected returns, investors frequently trading in and out of this fund run the risk of eating up their returns.

Fundamental View
U.S. Treasury bond yields have spent the past several years hovering around all-time lows. As of this report, two-year Treasury bonds were yielding 0.64%. This is near the top of its range over the recent three-year period through April 2015, when the two-year Treasury traded in a range between 0.26% and 0.73%. 

By historic standards, however, the fund's current yield is still relatively low. Extending back a decade, the two-year Treasury yield traded as low as 0.16% (September 2011) and as high as 5.29% (June 2006), averaging 1.71% over the entire period. With the current yield near all-time lows, there's little room for any price appreciation. 

Treasury bonds have performed very well in the past few years, but going forward, the potential for rising interest rates is a big concern. The Federal Reserve may begin raising the Fed funds rate, which has been near 0% for the past several years, in the back half of 2015. The current unemployment rate of 5.4% (as of May 2015) is well below its 6.5% target. However, there is still plenty of slack in the economy, and inflation remains stubbornly low. 

This may sway the Fed to keep a lid on rates in the near future, but at some point rates will rise, and when that happens, the fund likely will suffer losses. Investors can keep an eye on the Consumer Price Index for signs that inflation is picking up. If inflation ticks up quickly, the Federal Reserve may have to intervene and raise rates. Remember that if inflation turns out to be greater than the fund's nominal yield over the next few years, then the real yield (and likely the total return) for this fund probably will be negative.

John Gabriel is an ETF strategist with Morningstar and contributor to Morningstar ETFInvestor. Click here for a free issue.

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