FREE NEWSLETTER
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%.
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:
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.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
How do I compare inflation protected short-term funds to the nominal variety? There has to be some sort of premium for that protection. Is it worth it? Or is it pretty insignificant. Also, the phantom tax makes I-P better in tax advantaged accts. I would need more fixed income so the remainder of nominal S-T treasurys would be on the taxable side. I’m not sure if that’s right.
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.
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.
Thanks for your excellent column, Mike. I have a question about the 2.26% yield to maturity that you quote. Assume 4 things:
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.
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!
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.
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.
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.
Could be an option. 2.89% yield to maturity as of Mar 24. Duration of 5.5. (Using symbol: GNMA as the proxy.)
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
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.
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?
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
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).
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).
Thanks, Mike. That is helpful.
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.
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).
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?
Big questions! I’ll leave those for another day. The USD has appreciated as geopolitical tensions have risen though.
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.
Thanks Bill! Yeah, I have some AGG. Maybe I should park that in SHY for now, but eh.. status quo bias 🙂