SHY ETF: Stable Vehicle During A Market Sell-Off, 2.09% Yield

Thesis

The iShares 1-3 Year Treasury Bond ETF (NASDAQ:SHY) is a vehicle that as per the fund’s literature “seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities between one and three years“. The fund is credit risk free and in a normalized interest rate environment represents an optimal portfolio allocation tool to park cash. Late last year we wrote an article advising retail investors to keep their spare funds in cash for the foreseeable future given the upcoming tightening cycle. The Fed did not disappoint, with the 2-year yields now up by more than 200 bps since the start of the year. SHY was not immune to this move from a NAV perspective, being down almost -3% year-to-date. With the Fed considering 2.4% as a neutral rate, we can observe that front end yields have surpassed that level. We believe most of the move is now behind us, and given SHY’s short duration of 1.89 years the fund is well suited to expose a stable NAV going forward and now offers an attractive 30-day SEC yield of 2.09%. We discuss below in detail why the 30-day SEC yield analytical metric is the correct way to look at SHY, rather than the fund’s dividend yield. We thus feel SHY is back to being a suitable and attractive cash parking vehicle for retail investors, and we rate it a Buy.

Dividend Yield vs 30-day SEC Yield

Dividend Yield

Usually financial websites show a trailing 12-months dividend yield when reporting this metric. For example if you look at SHY on Seeking Alpha you will notice that the dividend box shows a 0.32% ratio – when looking into the details of how this is calculated (go to the Dividends tab – Dividend History) you will notice that this metric is actually calculating by adding the dividends paid out in the past 12 months and then annualizing that figure as compared to the current fund market price. In a stable interest rate environment this metric is suitable, but in an increasing / decreasing interest rate environment looking at this analytic would be very misleading (as rates go up the dividend yield would be understating what you are getting for example).

30 Day SEC Yield

This is the best metric when analyzing a short duration bond fund given the current interest rate environment and the propensity for some funds to have a roll effect in their bond holdings, where the discount to par is being absorbed by the maturity pull and higher yielding bonds are bought. This creates an effect of having a much higher 30-day SEC yield when compared to a trailing 12 months dividend yield. The 30-day SEC yield is the best metric to look at when considering short duration bond funds because it gives you an accurate snapshot of what cash you are actually going to receive based on where the portfolio currently is, and where the market price clears. Taking the same example as above we will notice that SHY has a 2.09% 30-day SEC yield vs 0.32% reported dividend yield.

Performance

SHY has not been spared by the relentless rise in front end yields in 2022:

The fund is down almost -3% on a price basis given the sharp rise in 2-year yields. However, we can notice that on a long term basis the NAV performance is very stable, making it an attractive cash parking instruments in a normalized interest rate environment:

When you look at a short-term fund for a wider historical period you want to see a stable NAV since the purpose of the fund is to distribute a dividend yield that is in accordance with prevailing rates and provide stability from a NAV perspective for the entry and exit. From the above table we can see that while in the past year the fund is down due to rates, on a 10-year basis it has barely moved, being up only 0.71%. This is the type of performance we expect from these types of funds.

Interest Rate Environment

2-year yields are nearing highs not seen in over a decade:

We can see from the above graph of 2-year CMT rates that we are closing in on the highs seen in 2018, and some of the highest levels in over a decade for this point in the curve. The move has been abrupt and violent – if we look at the graph and the slope of the upwards curve we realize the violence of the rates re-pricing in the market. Nobody wants to be caught behind the bonds move so the market has been very aggressive in pricing the next steps to be undertaken by the Fed.

(Source)

Some banks are now even penciling in Fed Funds rates close to 4%:

While the OIS curve only implies a rate a bit north of 3% for Fed Funds, Nomura now put out a research piece where they see rates coming close to 4%. We think this is far-fetched and geared more towards garnering attention by being the outlier bank with the most aggressive rate call. We re-iterate our stance where we see rates revisiting the 2018 highs with a very front-loaded schedule, but we do not think we are going to go much further out than that. We see an aggressive Fed this summer followed by a very slow tightening schedule and a “wait and see” attitude from the Fed in terms of real economic impact derived from the higher rates levels.

(Source)

Conclusion

SHY is an ETF that gives an investor exposure to short term treasury yields. While last year, given the low rates environment, the vehicle did not yield much, SHY now offers rates in excess of 2% and they will increase even further given the current yield curve. We feel the bulk of the market rates moves are behind us, thus the fund’s NAV is going to be stable going forward. SHY is now reverting to being a stable NAV short term cash parking vehicle that investors can use when fearing a market sell-off, but still desiring to get paid some dividend yield for held funds. We now rate SHY a Buy.