Providing Shelter From Market Volatility

After new Federal Reserve Chairman Jerome Powell's testimony on Feb. 27, both the Dow Jones Industrial Average and S&P 500 fell about 1%, while the 10-year Treasury bond yield jumped to 2.9% from 2.4% just two months ago. Powell's statements reflected his view that the labor market is strong and inflation is moving up to target, which, in turn, signals the Fed's continuation of its tightening policy. While investors shouldn't make dramatic changes based on anticipated rate increases,

This fund invests in Treasury securities with less than a year remaining until maturity, taking minimal credit and interest-rate risk, which translate to a low yield. Accordingly, pricing is one of the most important factors driving returns for funds in the ultrashort bond Morningstar Category. This fund enjoys a durable cost advantage over most of its category peers, but there are even cheaper alternatives, which limits the strategy to a Morningstar Analyst Rating of Bronze.

This fund invests only in short-term Treasury bonds. So it offers a lower yield than the typical category peer with a portfolio of both government-related securities and higher-yielding (and riskier) corporate bonds. Its duration of 0.5 years is on par with the category norm, insulating the fund from rate fluctuations. The resulting SEC yield was 1.2% compared with the category norm of 1.5% as of December 2017.

While the strategy went through an index change from the Bloomberg Barclays U.S. Short Treasury Index to the ICE U.S. Treasury Short Bond Index in July 2016, the two indexes are virtually identical. This fund has maintained a strong index-tracking record throughout. The portfolio gained 0.4% annually over the trailing 10 years through December 2017, lagging its index by 0.1%. This gap was less than its 0.15% expense ratio.

During the same period, the strategy trailed its peer average both on an absolute and risk-adjusted basis, measured by Sharpe ratio. This underperformance was attributable to its conservative credit profile relative to peers that held riskier and higher-yielding corporate obligations. But its five-year maximum drawdown through December 2017 ranked in the top 10% of the category, showcasing its downside protection.

Fundamental View The U.S. Treasury Department issues Treasury securities to fund federal government operations. These bonds have virtually no default risk as the government can raise taxes to repay the debt. Accordingly, Treasury securities offer a very low yield. As of Feb. 1, 2018, the one-year Treasury bond yielded 1.8%, 30 basis points lower than the 20-year average (1998 to 2017). Interest income on Treasury securities is tax-exempt at state and local levels, slightly improving the aftertax yield.

To improve returns, the fund's typical peer allocates roughly one third of its capital to corporate bonds--mostly A or BBB rated securities. While neither A nor BBB rated bonds defaulted from 2014 to 2016 (2017 data is currently unavailable) according to S&P, these bonds still pose credit risks. Treasury bonds are explicitly guaranteed by the U.S. government and have virtually no credit risk.

In addition, the fund takes similar interest-rate risk to the category norm, resulting in a low yield and low potential return. The fund offered a 1.2% SEC yield as of December 2017, compared with the category average of 1.5%. The fund posted modest three- and five-year gains of 0.3% and 0.2% through the end of 2017, respectively, both behind the corresponding category average return. Its risk-adjusted return, calculated by Sharpe ratio, was behind its typical peer because of relatively muted bond-market volatility during the past few years.

However, this fund has offered good downside protection. In fact, the fund had only one money-losing year from its 2008 inception through 2016: 2015, when it declined by 0.01%. The fund's worst downturn over the trailing three- and five-year periods through December 2017 was among the mildest in the category, ranking in the top 20% for both periods. It should continue to weather market downturns better than most of its peers.

Portfolio Construction The fund earns a Positive Process rating because it accurately captures the short-term Treasury market and weights its holdings by market capitalization. This weighting approach tilts the portfolio toward the most-liquid issues, which helps promote low transaction costs.

The fund uses a sampling strategy to track the ICE U.S. Treasury Short Bond Index, which measures the performance of U.S. Treasuries that have between one month and one year until maturity. The index includes publicly issued U.S. Treasury securities that have at least $300 million in outstanding face value, excluding amounts held by the Federal Reserve. Excluded from the index are inflation-linked securities, cash management bills, any government agency debt, and zero-coupon issues that have been stripped from coupon-paying bonds. The index is weighted by market capitalization, and the constituents are updated on the last business day of each month.

Prior to July 1, 2016, the fund tracked the Bloomberg Barclays U.S. Short Treasury Index. There were no meaningful changes in the performance and characteristics of the fund after the change. BlackRock made the change to diversify its services providers and benefit from ICE's operational expertise in providing fixed-income pricing.

Fees The fund has an expense ratio of 0.15%, which is among the lowest in the ultrashort bond category, supporting the Positive Price Pillar rating. This fee is much lower than the 0.40% category average, ranking in the cheapest decile of the category. In addition, this fund has tightly tracked its underlying index since its index change in July 2016 thanks to effective management. From July 2016 to January 2018, the strategy lagged its benchmark by 0.16%, which was in line with its expense ratio.

Alternatives

Gold-rated

High-yield online savings accounts are also worthy options to explore. Marcus, a retail arm of Goldman Sachs, offers a savings account with a 1.50% annual percentage yield and a maximum deposit of $1 million. American Express has a similar product with a 1.45% annual percentage yield and a maximum balance of $5 million. Both products are FDIC insured up to $250,000. These accounts charge no fees, but they are less liquid than exchange-traded funds and mutual funds. There is a limit of six withdrawals or transfers in a month for both products.

Disclosure: Morningstar, Inc. licenses indexes to financial institutions as the tracking indexes for investable products, such as exchange-traded funds, sponsored by the financial institution. The license fee for such use is paid by the sponsoring financial institution based mainly on the total assets of the investable product. Please click here for a list of investable products that track or have tracked a Morningstar index. Neither Morningstar, Inc. nor its investment management division markets, sells, or makes any representations regarding the advisability of investing in any investable product that tracks a Morningstar index.