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Standard & Poor's


07/24/14 05:08:01 PM


After climbing higher in the second half of 2013, interest rates reversed course in the first half of 2014. Now the yield for the 10-year Treasury bond is under 2.5%. Where does it go from here and how should investors position their portfolios remains a hot topic for discussion.

In testimony to Congress last week, Fed Chair Janet Yellen said the Fed funds rates will remain near zero in an effort to continue to stimulate the economy. "Even with the recent declines, the unemployment rate remains above Federal Open Market Committee participants' estimates of its longer-run normal level," Yellon said before the Senate Banking Committee. "Labor force participation appears weaker than one would expect based on the aging of the population and the level of unemployment."

According to the U.S. Bureau of Labor Statistics the unemployment rate fell in June to 6.1%, as of June 2014, only 63% of Americans over the age of 16 participate in the labor force, around the weakest level since the early 1980's.

Yellen's testimony, combined with elevated tensions in Eastern Europe and the Middle East that we believe has caused a recent flight to the quality, via U.S. Treasuries, contributed to the yield on the 10-year government bond falling further. However, Yellen's views also serve as a reminder that rates will ultimately move higher.

"If the labor market continues to improve more quickly than anticipated by the committee, resulting in faster convergence toward our dual objectives, then increases in the federal funds rate target likely would occur sooner and be more rapid than currently envisioned," she said. "Conversely, if economic performance is disappointing, then the future path of interest rates likely would be more accommodative than currently anticipated."

Simply stated, when interest rates rise, bond prices fall. The degree of price decline is determined by a bond's duration. For instance, given a 100 basis point (bp) increase in rates, a note with duration of eight years will see a price decline of about 8%, while a three year duration note will decline approximately 3%. For example, iShares 7-10 Year Treasury Bond (IEV 104 Overweight) has average duration of 7.7 years and thus potentially takes on elevated interest-rate risk.

As such investors concerned about rising rates should give a close look to those ETFs that have relatively low duration. But also they should look inside since not all short-term ETFs are the same. In ranking bond ETFs, S&P Capital IQ takes into account the credit quality, duration, yield into account, in addition to reviewing performance and cost attributes.

Vanguard Short-Term Bond Index (BSV 80 Overweight) launched in 2007 and has over $14 billion in assets. The ETF has an average duration of 2.7 years and recently had a 30-day SEC yield of 0.9%. Most of the bonds inside are issued by the U.S. Government and thus has strong credit quality, though investment-grade corporate bonds are also held. The ETF, which has 0.10% expense ratio, trades with a $0.01 bid/ask spread.

Meanwhile, iShares Short Maturity Bond (NEAR 50 Overweight) launched in 2013 and has over $300 million in assets. The average duration is just 1 year, yet it has a slightly higher 1.1% 30-day SEC yield. This, we believe, is the result of holding mostly corporate bonds with lower-investment grade (A-rated or BBB-rated) bonds. NEAR has a 0.25% expense ratio and also trades with a $0.01 bid.

Reports on these ETFs and others will modest durations can be found on this platform.


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