iShares Short Treasury Bond ETF: Too Conservative In A Falling Rate Environment – iShares Short Treasury Bond ETF (NASDAQ:SHV)

The iShares Short Treasury Bond ETF (NYSE:SHV) is a low-duration, low-volatility, “cash alternative” exchange-traded fund that invests in short-term U.S. government treasury bills and notes with a maturity of less than 1 year. This is one of the most conservative vehicles you can invest in, and as such, the focus is really on capital preservation with access to daily liquidity. Investors here get a monthly dividend, which is based on the interest earned from the treasuries portfolio, as the fund constantly tracks short-term rates by buying more bills as the existing portfolio matures. With that said, we think it’s unnecessary to settle for the objectively meager returns here and highlight some other short-term, low-duration ETFs that have a similar risk profile with a slightly higher return potential. This article covers the characteristics of SHV and our view on why this is not our pick within the short-term bond segment of ETFs.

(Source: StockCharts.com)

Profile

For investors who are not familiar with short-term bond ETFs, the idea here is simply a place to park your money with little to no risk of capital loss. Indeed, the dividend adjusted stock chart is basically a straight line where the value appreciates as the distributions are reinvested. As the Fed hikes or lowers the funds rate, short-term market yields will tend to track the trends in the overnight rate. The current 3-month treasury rate is 1.96%, while the 1-year rate is currently at a lower 1.73%. This inversion here reflects the expectation that in one year’s time the market rates will be lower.

Data by YCharts

Data shows that the dividend yield for SHV is 2.22% on a trailing twelve-months basis. The current weighted average yield to maturity for SHV’s treasuries portfolio is 1.88%, although this is not an indication of an actual forward dividend yield, which will depend on market rates over the next year as the portfolio is regularly turned over. It’s safe to assume the forward yield will be lower, as market rates decline with further rate cuts by the Fed. Between 2010 and 2015, when the Fed Funds rate was at 0.0% at the lower bound, SHV basically had zero return. Again, the point here is a place where your cash balance is safe. A potential 1.88% return (or zero) may not appear exciting, but it could be better than a negative return from holding risk assets.

Data by YCharts

The use of SHV within an investment portfolio can serve two purposes:

1. Adding the short-term, low-duration fund to an existing allocation of fixed-income securities will likely reduce the overall risk level of the portfolio. An example here would be re-balancing from high-duration bond funds to SHV as a hedge against a rise in interest rates.
2. The monthly dividend serves a function of income generation, while maintaining low-to-negligible volatility of the principal.

SHV: Low Risk, Low Reward

As a standardized measure of risk, SHV’s effective duration at 0.43 years means that the average holding on a weighted basis matures in about 5 months. We point out that there are some options among short-term bond funds that have a similar effective duration levels, with the key difference in that they invest in corporate fixed-income securities. The tradeoff is that by assuming some credit risk, the funds offer marginally higher yields and return potential relative to treasuries.

Of course, corporate bonds face the risk of default, but in the examples below, these ETFs are typically invested in high-quality securities. The JPMorgan Ultra-Short Income ETF (JPST), for example, has over 73% of its portfolio invested in “A” rated or better bonds in a diversified portfolio with 631 holdings. There is a case to be made that in an extreme scenario where corporate defaults surge, SHV would outperform, but in our opinion, the credit spread and yield from corporates over treasuries is worth it. We think SHV is just too conservative for most market environments.

With a peer group including JPST, ICSH, GSY and NEAR, we highlight that all have an effective duration between 0.42 and 0.48. This list is not all-inclusive, and there are other funds available with similar risk profiles, but the group here in particular is selected based on size and liquidity.

Data by YCharts

Compared to SHV, which has returned 2.42% on a total return basis over the past year, JPST, up 3.21%, is the best performer, followed by ICSH returning 3.14%, GSY 3.11%, and NEAR up 2.96%. These funds also have a higher average yield to maturity, which implies a higher forward dividend yield. The similarity among the funds is that they all pay a monthly distribution. The alternatives to SHV presented here all offer a higher return because they invest in corporates that are higher-yielding compared to treasuries. We note that ICSH and NEAR are from the same iShares fund family but are actively managed, with the fund managers selecting the composition based on quality and risk parameters screened for value. ICSH also invests in credit securities like securitized loans.

ICSH is our top pick in this group, as it has the lowest expense ratio at just 0.08%, compared to 0.25% for SHV and 0.18% for JPST. Our view is that investors should make every basis point count.

Forward-Looking Commentary

SHV and other cash alternative funds perform best in an environment of rising interest short-term rates as the yields trend higher. Still, we think funds that invest in corporate bonds and credit securities are a better alternative for most investors.

Within the current macro environment, a scenario that could lead to higher short-term rates would be a quick and favorable resolution to the U.S.-China trade dispute, resulting in a renaissance of global growth expectations and demand-based inflation pressures. While not our base case, should such an even occur, the Fed could be forced to reassess the rate cut cycle and consider rate hikes to anchor inflation expectations. Short-term rates would rise, and the yield curve likely steepen, resulting in large losses for high-duration type bond funds.

Data by YCharts

With an expectation of further rate cuts by the Fed and an uncertainty of where the easing cycle will end, the main concern is that short-term rates fall to approach zero as they did between 2009 and 2016. The monthly distributions would decline to a dividend yield of zero. The credit spread from corporate bonds should result in a yield advantage in most market scenarios.

Takeaway

SHV, with $24 billion in total assets under management, holds an important place in the universe of investable securities in that it provides investors access to effectively risk-free treasuries through an actively traded ETF. For the purposes of capital preservation and a marginal monthly income, we think investors can do better than simply hold short-term treasuries. The yield on SHV is worth monitoring as a benchmark for other “cash alternative” funds.

Disclosure: I am/we are long JPST. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.