Play Defense With This Treasury ETF

Ultrasafe investments, like short-term Treasuries, are an effective way to diversify an all-stock portfolio as they tend to hold up well during periods of market distress. Treasuries are backed by the full faith and credit of the U.S. government, so they don't carry the credit risk that is embedded in corporate bonds. Those with relatively shorter maturities are less sensitive to changes in interest rates than their longer-maturity counterparts. But this high degree of safety means they won't provide exceptional returns. So, keeping costs low is an important consideration when choosing a Treasury fund. Schwab Short-Term U.S. Treasury ETF SCHO provides great exposure to these stable assets. Its strong index-tracking record and rock-bottom price tag support a Morningstar Analyst Rating of Silver.

This exchange-traded fund tracks the Bloomberg Barclays U.S. Treasury 1-3 Year Index, which includes Treasury bonds with one to three years remaining to maturity. Indexing Treasuries in this way is a sound approach for exposure to a specific portion of the yield curve. It is difficult for active managers to recoup their fees while offering comparable exposure to Treasuries on this narrow segment of the yield curve, as Treasuries are one of the most competitively priced areas of the bond market and managers have little leeway to take additional duration risk. And they can’t take additional credit risk without venturing into other areas of the market. Active Treasury bond managers derive most of their active returns from yield-curve positioning. Those strategies, or broader Treasury index funds, may be more suitable for those who don’t have a view about the best place to be on the yield curve.

This portfolio has low interest-rate risk, but it tends to offer lower return potential than funds that invest in longer-maturity bonds. The shape of the yield curve can influence the attractiveness of this trade-off. When the slope of the curve is gentle, the opportunity cost of investing in short-term Treasuries is low. But as the curve steepens, so does the potential opportunity cost. This ultrasafe portfolio provides strong downside protection because short-term Treasuries tend to act as a safe-haven asset during periods of distress.

This ETF takes less interest-rate risk than the short government Morningstar Category average. Its volatility hovered near the bottom third of the category between August 2010 and February 2019. But its returns were mediocre over this stretch. Its low fee ranks among the cheapest in the category and should provide it with a durable edge over its more expensive peers.

Fundamental View The U.S. Treasury Department issues Treasury bonds to fund federal government operations. These bonds have virtually no default risk as the government can collect taxes to repay the debt. Accordingly, Treasuries offer lower yields than other bonds, such as those issued by corporations. Interest income on Treasury securities is tax-exempt at the state and local levels, which improves their aftertax yield.

Many funds in the short government category supplement their Treasury holdings with agency mortgage-backed securities to improve performance. These bonds carry high credit ratings. But unlike Treasury bonds they carry prepayment risk because borrowers have the option to pay their mortgage off before maturity. This feature exposes investors to reinvestment risk, or the risk of reinvesting the prepaid principal at a lower yield than before. As a result, these bonds offer slightly higher coupons to compensate for this risk, so the fund’s yield to maturity will likely lag the category average as it has done in the past.

The fund’s category peers also take on more interest-rate risk by holding longer-maturity bonds. As a result, the portfolio’s duration is about a half year shorter than the category average, so it will be less sensitive to interest-rate changes than a typical competitor. The Federal Reserve raised interest rates by 1 percentage point in 2018, and the fund’s total return beat the category average by 37 basis points for the year.

This portfolio's returns have kept up well with its category peers in recent years despite not owning any agency MBS. It beat the category average by 10 basis points annually over the trailing five years through February 2019. This mild outperformance was driven principally by its low expense ratio, which compensated for the yield differential.

Furthermore, this fund offers good downside protection. Treasuries tend to hold up better than most bonds when markets go through stressful periods. The fund’s returns beat most of its category peers when the price of oil and related energy stocks declined in 2015. It has also weathered bond market downturns better than many of its competitors. The fund’s total return landed in the top decile of the category when the Fed began reducing its asset purchase program in 2013, causing yields to rise. Given the fund's cost advantage and low-risk holdings, it should continue to generate attractive category-relative risk-adjusted performance over the long haul.

Portfolio Construction The fund earns a Positive Process rating because it accurately captures the short-term Treasury market and takes steps to curb transaction costs. The managers use near full replication to track the Bloomberg Barclays U.S. 1-3 Year Treasury Bond Index. This benchmark includes all publicly issued U.S. Treasury bonds with one to three years remaining until maturity and at least $250 million in outstanding face value. It holds only fixed-rate, nonconvertible bonds denominated in U.S. dollars. The index weights its final holdings by market value, which promotes low trading costs by tilting the portfolio toward the most-liquid bonds. The index reconstitutes on the last business day of each month.

Fees This is one of the cheapest funds in the short government category and earns a Positive Price Pillar rating. Schwab charges just 0.06% annually for this portfolio, making it cheaper than almost all of its rivals. The fund's total return lagged its target index by 8 basis points annually over the trailing three years through February 2019, an amount comparable to its expense ratio.

Alternatives Silver-rated Vanguard Short-Term Treasury ETF VGSH (0.07% expense ratio) is the closest alternative because it tracks the same index as SCHO.

Bronze-rated iShares 1-3 Year Treasury Bond ETF SHY tracks the ICE U.S. Treasury Bond 1-3 Year Index and provides nearly identical exposure as SCHO but at a higher cost of 0.15%, making it less attractive. This market-value-weighted fund targets Treasury securities with between one and three years until maturity. Qualifying bonds must have $300 million in face value, which is higher than SCHO’s requirement by $50 million. This difference can potentially improve liquidity when the fund rebalances. However, the net impact is likely minimal.

Silver-rated Vanguard Short-Term Federal VSGBX (0.20% expense ratio) is a solid actively managed option. It holds bonds with one to five years remaining to maturity and includes allocations to agency and MBS, which improves its yield. The fund has a modestly longer duration than SCHO because it holds a small fraction of its assets in bonds with maturities longer than five years. So, it carries more interest-rate risk than SCHO.

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.