A Tactical Tool For Dialing Down Fixed-Income Risk

Market participants have been bracing for an eventual hike for a few years now. According to interest-rate futures, the market is assigning a 56% probability that the Federal Reserve will hike its target rate to 0.25% from 0% at its next meeting on June 17. So, it is far from a foregone conclusion that Yellen and company will start raising rates this summer.

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.

Investors seeking shelter from the impact from higher interest rates on their bond portfolio should consider the trade-off that comes with the fund's limited interest-rate risk. Any action by the Fed will have a much greater impact on yields at the short-end of the yield curve (where this fund's portfolio resides) than it will on intermediate or long-term rates. From a total return perspective, simply sticking with a diversified core bond portfolio may be the way to go. Longer-term securities contain more interest-rate risk, but their higher coupons can more than offset the price impact from a rate hike.

On the other hand, if preserving principal in the near term is the primary objective, then this fund will do the trick. The fund can be an effective short-term safe haven or a tactical cash substitute to rein in the interest-rate risk of a fixed-income portfolio and limit the price impact from an uptick in rates.

Portfolio Construction This fund tracks the short-term sector of the U.S. Treasury market as defined by the Barclays 1-3 Year U.S. Treasury Index. The fund employs a sampling strategy to assemble its portfolio of Treasury bonds, which generally has an average duration of around 1.8 years. It tracks its narrowly focused benchmark with a portfolio of around 100 securities. The fund pays distributions on a monthly basis.

Fees SHY has a low expense ratio of 0.15%. The fund's costs are competitive with other exchange-traded funds, but considering that the yield to maturity on the portfolio is 0.59%, expenses swallow about a fourth of the portfolio's income. This fund has done an excellent job tracking its index. It has an estimated holding cost of only 0.12%.

Alternatives Vanguard Short-Term Bond ETF BSV is an even cheaper option, with an expense ratio of 0.10%. Also, a fourth or so of BSV's holdings are in corporate bonds, which should provide higher yields for investors willing to take on the credit risk. For investors who are looking to take on a longer or shorter tenure, there is a whole host of offerings in the iShares, SPDR, and Vanguard ETF families to consider.

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