Insights on Exchange-Traded Funds

Bond ETFs: Opportunity in a rising yield market

Summer 2018

Key takeaways:

  • For the first time in almost a decade, bond yields are rising, offering meaningful income to investors.
  • Several central bank and macroeconomic trends lead us to believe that, barring unforeseen changes, bond yields may continue to rise, making this a good time for advisors to take a fresh look at bonds—particularly bond ETFs.
  • Most bond ETFs offer attractive attributes over actively managed bond mutual funds, including an index approach, lower costs, potential tax efficiency, and easy access.
  • For advisors who decide to make a tactical shift into bond ETFs, the SEC yield offers a standardized, straightforward calculation for assessing yield. And tracking price sensitivity via effective duration creates a more complete picture of where a fund’s yield and total return may be headed.

When the U.S. Federal Reserve adopted a zero-interest-rate policy as a way to stimulate growth after the financial crisis of 2007–2008, short-maturity bond yields dropped to near zero. Intermediate- and long-maturity bond yields also moved lower and remained at 50-year lows for a full decade.

During this low-rate decade, bonds served investors’ portfolios more for diversification and ballast than for return. But this is now beginning to shift. A strong U.S. economy and recent central bank actions have changed the picture for bonds, potentially bringing income back to the fixed income space.

At Charles Schwab Investment Management, we believe this may be a good time for advisors to take a fresh look at bonds—particularly bond ETFs—as income-generating assets that can help you accomplish your clients’ objectives.
 

Rising rates, rising yields

Bond yields have now risen to levels that offer meaningful income to investors, and investors appear to be reacting to these higher yields with increased allocations. Net flows into short- and intermediate-term bond ETFs have grown significantly, and we believe this trend is likely to continue (see sidebar below).

In less than one year, the yield and risk scenario for bonds has shifted remarkably. For example, on September 7 and 8, 2017, a 2-year U.S. Treasury was yielding 1.264%. Today, in mid-year 2018, the yield is over 2.5%. Likewise, a 5-year U.S. Treasury bond that was yielding 1.63% last fall now yields nearly 2.75%.

The market has moved decisively, and yields have come up quickly on the front end and in intermediate maturities (Exhibit 1).

Exhibit 1: Rate trends in 2-year and 5-year U.S. Treasuries

This change alters risk as well. Even 1.5 or 2 years ago, advisors needed to buy higher credit risk or longer-maturity assets to attain these yields. Now, not only are these yields available, but advisors can buy lower credit risk and shorter-maturity assets to earn the yields their clients seek.

Rate forces at play

Although no one can predict with certainty what rates will do, several central bank and macroeconomic trends lead us to believe that, barring unforeseen changes, bond yields will continue to rise.

  • After raising interest rates just once in 2015 and once in 2016, the Federal Reserve raised the Fed Funds rate three times in 2017, twice in 2018, and has telegraphed two more possible rate hikes this year.1
  • After buying over $3.5 trillion of U.S. Treasuries and mortgage-backed securities from 2009 to 2016, the Federal Reserve is now letting that balance sheet roll off through maturities. The projected cumulative maturities not reinvested in 2018 total $420 billion. This effectively increases the supply of treasuries and mortgage securities for the market to absorb by $420 billion.2
  • The European Central Bank, which followed a course similar to that of the Federal Reserve after 2008, announced on June 14, 2018, that they would halt bond purchases by the end of 2018.3
  • The U.S. economy is now operating at a healthy pace, with unemployment at 3.8%4 at the close of May 2018, the lowest it’s been since 1969.5 Upward wage pressure is beginning to produce inflation expectations. And looking beyond U.S. borders, the world’s top 45 economies all grew in 2017.6


Assets flowing into bond ETFs

In the first half of  2018, there have been significant net flows into bond ETFs, most notably into intermediate-term, ultra-short-term, and short-term bond ETFs (Exhibit 2).

Exhibit 2: Bond ETF net flows, first half 2016-2018

What is motivating advisors and investors to choose bond ETFs? One reason is that buying individual bonds can be very challenging. Unlike stocks, bonds don’t trade on a visible exchange, so determining fair value is difficult. To achieve diversification, advisors will often assemble bond portfolios or ladders. But managing a bond portfolio will likely lead to transactions, and costs can quickly add up.

Given these challenges, advisors who are ready to make a tactical shift into bonds may be drawn to actively managed bond mutual funds or indexed bond ETFs. Most bond ETFs offer a number of attractive attributes over actively managed bond mutual funds—including an index approach, lower costs, potential tax efficiency, and easy access.

Index approach

An index approach offers several considerations. The first is the confidence of knowing what you own and the knowledge that the fund will seek to track the returns of its index. When you buy a U.S. Treasury bond ETF, for example, you know you’re buying a U.S. Treasury strategy. Active bond mutual funds are more flexible in style and strategy, with human decision-making driving what to buy and when. Style drift and shifting risk are possible. And you may not know the effects until the 3-month look-back.

In the equities space, the SPIVA Scorecard7 results are clear. Most active managers have underperformed their index benchmarks over time. In fixed income, the data is more mixed. However, over the longer term, Morningstar and others have found that most active managers in the bond space also underperform their benchmarks (Exhibit 3).

Exhibit 3: Active intermediate-term bond funds that outperform their benchmarks

Thus, finding the right manager with the right strategy and the right timeframe for your clients over the longer haul—and then being able to outperform the embedded fees—remains a challenge.

Fees

Fees are another potential advantage of ETFs over actively managed mutual funds. In 2017, the average expense ratio for actively managed bond mutual funds was 0.81%.9 For index bond ETFs, it was just 0.24%.10 Some providers now offer bond ETFs with operating expense ratios as low as 0.04% to 0.06%.

Tax efficiency


A third advantage of bond ETFs is the potential for better tax efficiency. Bonds can appreciate, resulting in capital gain taxes for mutual fund holders when funds sell bonds with gains. In contrast, bond ETFs have structural advantages that can help facilitate tax efficiency, often avoiding capital gains.

Easy access

And finally, buying a bond ETF is as easy as buying an individual stock. The price is displayed on an exchange. All you need is the ticker.

Given all these advantages—the long-term performance of index strategies, lower fees, tax efficiencies, and ease of access—investing in bond ETFs is an attractive alternative to buying individual bonds or actively managed bond mutual funds. Strong investment flows into bond ETFs suggest advisors are making tactical allocations in response to the rising yields.

Key considerations: Yield and beyond

For advisors who are making a shift toward bond ETFs, there are three concepts to consider: yield, price sensitivity, and effective duration.

Yield is a backward-looking annual percentage used to express the investor’s return on a bond or fund. But evaluating yield in a bond ETF is not a simple process. That’s because there are a dozen or more yield measures used by bond fund and ETF providers (Exhibit 4).

Exhibit 4: Common yield measures

Making the picture even more complex, different yield measures can deliver different yield numbers, particularly when rates are moving, as they have in the last six to nine months. For example, in Exhibit 5 we display three common yield measures for the Schwab Short-Term U.S. Treasury ETFTM to show the remarkably different yields produced by these formulas and reporting periods.11

Exhibit 5: Comparing yield measures

The SEC yield in this example is +1.21% higher than the distribution yield TTM because of the different underlying methodology for each measure. Specifically, the distribution yield TTM includes income generated by the ETF over the previous 12 months. This includes the dividends that the fund delivered in 2017 before the rate rise, whereas the SEC yield will always reflect the most recent 30-day period.

SEC yield as a standard approach

We recommend that advisors use the SEC yield as the foundational yield measure. Of the major measures, the SEC yield has some significant advantages:

•       It is mandated by the SEC
•       Calculation method is consistent across all providers
•       It must be included in all fixed income ETF fact sheets

The SEC yield offers a fairly timely (previous 30 days) look at the yield. It takes cost into account, whereas other yield measures may not include the cost of the funds. And it is standardized. In the distribution yield, for example, some providers base it on 30 days, some on the previous quarter, some on six months, and some on one year.

Because the SEC yield is required by the SEC, it is calculated consistently (Exhibit 6) and made available by all providers. It measures the previous 30 days of both income and changes to principal and then annualizes the number. If the principal and incomes vary, then the SEC yield will as well.

Exhibit 6: Calculating the SEC yield


Considering price moves

Keep in mind that a bond’s total return is a function of more than just yield. Total return also includes price returns. So even with the higher bond yields now available, some advisors may still be concerned about declining bond prices if interest rates continue to rise. As rates rise, the market price of fixed income investments—such as bond ETFs—typically drops. As rates fall, market price typically rises.

Advisor concern over declining bond prices is understandable. However, no one can know the future of interest rates or when they’re likely to reach their peak. And in our view, the rise in bond yields in the last year may have provided some cushion for short- to intermediate-maturity bonds to absorb a moderate amount of future price decline, should that occur.
 
The relative impact of yield moves, or how much the price of a bond or bond ETF will move, is known as price sensitivity. This is conveyed by effective duration.

Effective duration

In this measure of a portfolio’s price sensitivity, the longer a fund’s duration, the more sensitive the portfolio is to shifts in interest rates (read more about this in the box below). Longer maturities and smaller coupons tend to increase duration, while shorter maturities and larger coupons decrease duration. In other words, the front-end and intermediate bond yields, which have risen more than longer-duration yields, also contain less price sensitivity if rates move higher.

The higher a bond ETF’s duration, the more sensitive its price will be to interest rate moves. For instance, a portfolio with a 10-year duration is about twice as volatile as a portfolio with a 5-year duration.

Looking at duration and price sensitivity

A bond ETF with a 1-year effective duration will move in price very closely to an inverse move in its yield to maturity. In other words, if the yield to maturity moves up 100 basis points, the price will decrease by 100 basis points (1%/100 = 1 basis point or .01%). An ETF with a 2-year effective duration will have an estimated price move of two times the inverse yield increase.


Bringing it all together

With the rise in U.S. interest rates, bonds typically deliver higher yields and incomes than have been seen in several years. As a result, bond ETFs, and most notably short- and intermediate-term bond ETFs, are garnering a growing share of ETF inflows. The yield in the front end of the curve, coupled with reduced risk to future rising rates than longer dated bonds, translates into an attractive relative value.

When evaluating the income characteristics of a bond ETF, the SEC yield offers the most consistent comparison between ETFs. Keep in mind that price sensitivity via the effective duration offers a more complete picture of where the yield and total return of a fund may be headed. There is no crystal ball to see the future, but the different measures can be considered in combination to help compare and contrast bond ETFs and find the funds that are the best fit for your clients’ income and overall portfolio needs.

About the author




D.J. Tierney is a Managing Director and Client Portfolio Strategist supporting Charles Schwab Investment Management, Inc. (CSIM). In this role, he represents Schwab ETFs™ to sales channels, clients, and the media. He also works with CSIM’s product team to optimize Schwab’s ETF offerings. Mr. Tierney assists in managing relationships and communications for Schwab ETFs with authorized participants, broker-dealers, and regulatory agencies. Prior to joining Schwab in December 2016, Mr. Tierney spent 16 years with Morgan Stanley as a senior institutional sales, trading, and relationship management professional. Mr. Tierney earned a BA in economics from the University of California, Los Angeles, and an MBA from the University of California, Berkeley, Haas School of Business.

Download this articleDownloadPrintPrint

Register now for even more

Access resources developed for institutional use only—and subscribe to receive our latest news and insights.

Register


Download article  >

Article Archives

Read previous ETF Insights

Article Archives >

Schwab ETF News

Now the 5th largest provider of ETFs, Schwab has become a disruptive force in the ETF industry.

Read more

More News & Events >

Insights

A monthly review of the latest developments in the exchange traded funds marketplace.

Read More

Your due diligence guide to ETFs

Read More



Navigating the growing ETF landscape.

Watch video


More ETF Insights >

Learn More About Schwab ETFs >