FREE NEWSLETTER

Treading Gingerly

Mike Zaccardi

AS INTEREST RATES head higher, where should bond investors turn?

A lot of ink has been devoted to Series I savings bonds—for good reason. The initial yield, which applies to bonds bought through April, is north of 7%. Come May 1, it might go even higher if the inflation rate continues to climb. The recent energy price surge wasn’t fully reflected in February’s Consumer Price Index, so the coming months’ reports could be even more alarming.

Problem is, there’s a limit to how much you can invest in Series I bonds, which are sold through TreasuryDirect. The annual purchase cap is $10,000. You can also put up to $5,000 of your federal income-tax refund into I bonds, though you must take delivery of physical bonds. You then have the option of converting them to electronic form.

What if you have even more money to stash in bonds? Check out short-term Treasury exchange-traded funds (ETFs). Right now, you can buy iShares iBonds Dec 2024 Term Treasury ETF (symbol: IBTE) and earn a respectable, safe yield to maturity of around 2.2% a year over the next two-plus years. That beats the pants off a high-yield online savings account, which might offer a measly 0.5%. Other choices include the iShares 1-3 Year Treasury Bond ETF (SHY) and Vanguard Short-Term Treasury ETF (VGSH).

Why is there such a large yield gap between savings accounts and very low-risk Treasury funds? Short-term Treasury rates have jumped recently as the Federal Reserve starts to raise rates. The two-year Treasury rate, which was 0.2% six months ago, has vaulted above 2.1%. Another reason for the surge in near-dated maturities is the rapid rise in two-year inflation expectations. They were near 3.3% in mid-February and are now just shy of 5%.

Rates on the long end of the Treasury curve haven’t seen that kind of volatility. They also don’t offer much of a yield premium. The iShares 25+ Year Treasury STRIPS Bond ETF (GOVZ) yields just 0.3 percentage point more than the low-duration iShares 2024 fund mentioned above. A lower duration means you’ll suffer less should market yields rise. The effective durations are 2.2 years for the iShares 2024 fund and 27 years for the iShares 25+ fund. That means that, for every one percentage point rise in market interest rates, the 2024 fund will lose about 2.2%, while the more rate-sensitive iShares 25+ fund will decline by a whopping 27%.

Our Free Newsletter

As rates rise from here, investors should keep reviewing their bond and cash investments. Owning a short-term Treasury ETF strikes me as a good choice right now, but that may change if yields spike higher across the bond market.

Some investors believe that owning bond ETFs and mutual funds, rather than individual bonds, is a mistake. I take issue with that. There’s a fallacy out there that bond funds are extra risky since a bond fund typically never matures, unlike an individual bond, which can be redeemed at maturity for its par value.

But consider this: A bond fund is comprised of individual bonds. Whether you own a basket of individual bonds or a bond fund, it’s essentially the same thing. Sure, when interest rates rise, a bond fund’s price drops—but so, too, does the price of an individual bond. In both cases, you’re looking at a potential loss if you need to sell right away. But when market interest rates rise, the bond fund offers a key advantage: It automatically invests proceeds from maturing bonds into new, higher-yielding bonds, plus it’s easy for shareholders to reinvest the interest they receive in additional fund shares.

Looking to invest in today’s bond market? Keep these four pointers in mind:

  • Think about shifting from savings accounts to a short-term Treasury fund now that rates have perked up.
  • Find out the yield to maturity for the bond funds you’re interested in. That’s a good guide to your likely return.
  • Check a fund’s duration. If a fund has a high duration, it’ll be roughed up by rising interest rates. Today’s low yields will likely provide scant compensation.
  • Tempted to buy corporate bonds, with their higher yields? Remember, you’re taking credit risk. You’ll receive extra interest for assuming that risk—but those bonds will also fall harder than Treasurys if the economy starts to slow.

Mike Zaccardi is a freelance writer for financial advisors and investment firms. He’s a CFA® charterholder and Chartered Market Technician®, and has passed the coursework for the Certified Financial Planner program. Mike is also a finance instructor at the University of North Florida. Follow him on Twitter @MikeZaccardi, connect with him via LinkedIn, email him at MikeCZaccardi@gmail.com and check out his earlier articles.

Do you enjoy HumbleDollar? Please support our work with a donation. Want to receive daily email alerts about new articles? Click here. How about getting our newsletter? Sign up now.

Browse Articles

Subscribe
Notify of
21 Comments
Inline Feedbacks
View all comments
Andrew Kuemmel
Andrew Kuemmel
2 months ago

Thanks for the good column Mike. As a public school educator, the primary fixed income choice in our 403(b) is a stable value fund. I’ve read lots of posts here and elsewhere about bond funds, but very little about stable value funds. How should I compare the two? And would you please consider writing about stable value funds in the future? Thanks.

Mike Zaccardi
Mike Zaccardi
2 months ago
Reply to  Andrew Kuemmel

Thanks, Andrew. I don’t have a whole lot to say about stable value funds. I consider them as the money market fund of employer-sponsored defined contribution plans. In that light, a short-term Treasury fund might be offered in your plan. If you do hold some in the SV fund, you could think about shifting to a short-term Treasury fund. But you really should seek guidance from CFP advisor. It really comes down to your personal risk and return objectives.

Gary Cahn
Gary Cahn
3 months ago

Thanks for your excellent column, Mike. I have a question about the 2.26% yield to maturity that you quote. Assume 4 things:

  1. Let’s ignore the market changes that occurred the day you did your calculation.
  2. I bought the fund on the day you did your calculation
  3. I hold the fund until it dissolves in 2024
  4. Ignore the reduction in yield that occurs in 2024 because the fund holds the proceeds of sales in cash equivalents.

Is it reasonably certain that my return will be 2.26% plus or minus .05%

Or to put it another way, assuming the 4 caveats above, is the YTM a reasonably solid figure, or are there events that can cause it to rise or fall? (By events, I do not include events that have odds of occurring of 1000 to 1.

Thanks.

Mike Zaccardi
Mike Zaccardi
2 months ago
Reply to  Gary Cahn

Thanks, Gary! Yes, you are essentially describing the “net acquisition yield” which is the current YTM minus the expense ratio and +/- the market price difference vs NAV.
The YTM is generally considered the best estimate of what yield to expect going forward on a bond fund.
The downside is that if short-term rates continue to surge, then the NAV and market price will decline. On the flip side, if rates drop from here, buying today at a YTM near 2.3% will look like a great move.
I’m not suggesting this is like market timing–I’d rather take my chances owning short-term Treasurys than letting my cash sit at 0.5% in an online savings account. Full disclosure: I started buying IBTE when it was yielding 1.8%, so I am in the red so far!

Harold Tynes
Harold Tynes
3 months ago

The IBTE iShares iBonds Dec 2024 is an interesting investment. YTD Blackrock shows a yield of -2.9%. I’ve invested in several of the other iBond products on the commercial debt side such as IBDO. Quoting the Blackstone website “During the final year of the fund’s life, the underlying bonds will mature and the proceeds will be held in cash equivalents until the liquidation of the fund.” To overcome this reduction of yield, I usually sell the security at the end of the year before the maturity year and then invest out at the far range of my ladder, seven years.

Mike Zaccardi
Mike Zaccardi
3 months ago
Reply to  Harold Tynes

I show a yield to maturity of 2.26% on IBTE (probably more like 2.4% after today’s massive move in short-term rates).
You could just own SHY or VGSH–that way you don’t have to trade out of it.

John Daniels
John Daniels
3 months ago

What do you think of a low-cost GNMA fund (e.g., Vanguard) as a means of getting a little more yield than treasuries? Duration of GNMA funds is relatively short.

Mike Zaccardi
Mike Zaccardi
3 months ago
Reply to  John Daniels

Could be an option. 2.89% yield to maturity as of Mar 24. Duration of 5.5. (Using symbol: GNMA as the proxy.)

Last edited 3 months ago by Mike Zaccardi
PAUL ADLER
PAUL ADLER
3 months ago

Trying to understand how bond funds work.

Theoretically I own 100 shares of a short term bond fund with a NAV of $100. It has a duration of 2 years. The interest rate goes up 1% and does not change for 2 years.  
If I hold the fund for 2 years and reinvest the dividends what will my NAV be after 2 years and what would be the total value of the fund?

 Thanks

Mike Zaccardi
Mike Zaccardi
3 months ago
Reply to  PAUL ADLER

The fund NAV will remain below $100 (around the $98 level), but essentially you will benefit with lower-yielding maturity bonds being replaced with higher-yielding bonds (so the income yield improves).
The downside is that your principal (fund NAV) is reduced (as mentioned earlier). The fund’s NAV should be under $100 which is offset with a higher yield to maturity.

Ormode
Ormode
3 months ago

I am thinking of starting a ladder of 2-year Treasuries. I would invest the same amount each quarter for eight quarters, and then start rolling them over. When the ladder is fully built, I would probably be collecting about 100 basis points more than money-market funds are paying with little risk.
Opinions? Is it too soon?

Mike Zaccardi
Mike Zaccardi
3 months ago
Reply to  Ormode

Probably fine. I recommend checking out the iShares ladder tool. Very cool stuff with daily updates to YTMs and duration numbers.
https://www.ishares.com/us/resources/tools/ibonds

Jo Bo
Jo Bo
3 months ago

Thanks for the overview. Could you please explain more about the share price of how a bond ETF works in conjunction with year-end distributions? I’m still wondering why buying and laddering individual short-term bonds to hold to maturity wouldn’t be preferable to buying into a short-term ETF with a declining share price (other than the risk inherent with any single asset and the convenience of a single purchase).

Mike Zaccardi
Mike Zaccardi
3 months ago
Reply to  Jo Bo

Well, when a fund pays a distribution, the share price simply drops by that amount. In my opinion, owning a 1-3yr Treasury ETF is just fine compared to laddering (maybe better since you don’t have to trade in and out constantly).

Jo Bo
Jo Bo
3 months ago
Reply to  Mike Zaccardi

Thanks, Mike. That is helpful.

James McGlynn CFA RICP®
James McGlynn CFA RICP®
3 months ago

For those of us who went to the trouble of buying I-Bonds through Treasury Direct it is easy to buy 1 year T-Bills yielding 1.5%. Not a high yield but very high quality with no duration risk.

Mike Zaccardi
Mike Zaccardi
3 months ago

Well, there is duration risk with Treasurys. The idea is that if market rates rise, you lose out on the chance to get that higher yields. So your previously-purchased 1yr Treasury is worth less.
That being said, the duration on a 1yr Treasury is only.. 1yr (very small).

Mark Schwartz
Mark Schwartz
3 months ago

Great summary of the U.S. bond market. What happens to the US. Treasury bond market if the dollar is replaced on the world market either with a new world digital currency or maybe the Yuan? With what is going on with Russia in Ukraine and China chumming up with Russia one has to wonder what’s the end game?

Mike Zaccardi
Mike Zaccardi
3 months ago
Reply to  Mark Schwartz

Big questions! I’ll leave those for another day. The USD has appreciated as geopolitical tensions have risen though.

William Ehart
William Ehart
3 months ago

Good stuff Mike. My default over the past several years has been intermediate and short Treasury funds. The intermediates, in particular, have cost me of late. But I recently dipped a toe into short-term corporates because of the yield advantage and the fact that corporate spreads have widened to what I feel are normal levels.

Mike Zaccardi
Mike Zaccardi
3 months ago
Reply to  William Ehart

Thanks Bill! Yeah, I have some AGG. Maybe I should park that in SHY for now, but eh.. status quo bias 🙂

Free Newsletter

SHARE