I recently published an article encouraging investors to avoid long-term bonds because they currently offer extremely low incremental yield pickups per unit of duration (interest rate) risk—lower than ever before in history. I have encouraged selling not only long-term bond funds, but even core bond funds because they have so much exposure to long-term bonds.
Some people have asked me what I would recommend buying instead. The answer to that depends upon each investor’s particular objectives and circumstances. Traditionally, the bond allocation within an overall portfolio is used to diversify stocks, provide stability to a portfolio, and generate steady income. Those are all still important characteristics for the “non-stock” allocation of a portfolio.
In general, some combination of short-term corporate bonds, higher-yield bonds (junk, convertibles, and preferreds), yield-oriented equities (dividend growth, REITs, MLPs, utilities, energy, etc.), precious metals physicals and miner stocks, and other alternatives would provide a good substitute for a core bond portfolio. However, I would not necessarily use all of them at present.
But perhaps the largest allocation within a “core bond substitute” portfolio should be short-term corporate bonds. I specifically exclude government bonds because central banks have bid up their prices to such an extent that I believe they are not attractive investments. (An earlier article explains this assertion more fully.)
I invest in bonds mostly through ETFs. The purpose of this article will be to analyze the most attractive short-term corporate bond ETFs and recommend one or two for investment.
Defining the Universe of ETFs
I began the process of selection by starting with all ETFs identified as “short-term bond ETFs” by either ETF.com or ETFdb.com, a list of about 90 ETFs. I then used the following screens to pare the list down to something more manageable:
- Expense ratio <= .20% (cheap to own)
- Bid/ask spread <= .10% (cheap to trade)
- AUM > $500 million (not likely to be closed)
- No Treasury/government or broad market bond funds (investment grade corporate and muni only)
- No target maturity funds (permanent funds only)
I left the two short-term muni funds that passed all of these screens in the final list. The basic idea here is to reduce interest rate risk by shifting to short-term maturities, but keep most of the yield by emphasizing credit risk. Municipal bonds have some credit risk, so in that sense they are akin to corporate bonds.
Risks, Costs, and Yields
At Sapient Investments, we use four broad risk factors to measure and control those risks that tend to explain the majority of the returns for ETFs:
We measure the sensitivity of each ETF to these four risk factors simultaneously using exponentially-weighted multiple regression analysis over 36 months. When analyzing bond funds, it is important to use a multiple regression to separate the effects of market risk (MKT) from interest rate risk (LTB). Exponentially weighting the historical returns helps to make the sensitivity estimates more dynamic and forward-looking. Only the first two risk factors are meaningful for these ETFs, so we only display those in the table above.
Two kinds of risk drive bond returns: interest rate risk and credit risk. Duration mathematically measures interest rate risk. For example, a duration of 3.0 implies that the asset will lose 3% of its value if interest rates increase by 1%. There is no widely-recognized single measure of credit risk. However, because credit risk is related to many of the same risks that drive stock market returns, one way to estimate credit risk in a bond fund is with “market beta”—the statistical sensitivity of the returns of the fund to stock market returns. Our MKT beta is such a measure.
Our LTB beta is roughly analogous to duration. However, because the issuers provide a more accurate and up-to-date duration for their funds, we use that rather than our LTB beta to measure interest rate risk.
ETF issuers often provide several different kinds of yield calculations, including yield-to-maturity, yield-to-worst (applicable to callable bonds), and 30-day SEC yield. The last measure is “a standard calculation of yield introduced by the SEC in order to provide fairer comparison among funds. This yield reflects the interest earned after deducting the fund’s expenses during the most recent 30-day period.” (Definition taken from the iShares website.) It is the most comparable and fairest basis for yield comparison.
Making the two short-term muni bond ETFs comparable to the corporates requires the calculation of a “tax-equivalent yield.” I assumed a federal marginal tax rate of 32% which applies to single and head of household taxpayers with an income of $160,726 and married filing jointly starting at $321,451.
As shown in the graph below, the two floating-rate bond ETFs have extremely low durations because most of the assets owned by these funds have yields that reset so frequently that they have extremely short durations. In fact, both of these ETFs are based on the same index. The only differences are a .01% difference in bid/ask spread and a .05% difference in expense ratio. FLRN clearly dominates FLOT because its lower expense ratio.
The two short-term muni bond ETFs are depicted using green dots. SUB is the larger and older of the two and is an index fund. JMST was launched in 2018 and is an actively managed fund. From a yield/duration standpoint, the latter clearly dominates the former.
Excluding the two muni funds for the moment, it is clear that a combination of FLRN and IGSB dominates all other taxable bond ETFs, so it would appear that some combination of these two ETFs would be optimal for taxable investors based on the yield/duration tradeoff.
The graph below shows that all of the taxable short-term corporate bond funds have similar levels of MKT beta, which we are using as a proxy for credit risk. (All are within the margin of error in the MKT beta calculation.) Consequently, IGSB again rises to the top because of its superior yield.
Between the two muni bond funds, JMST appears to have a shade more credit risk, but again, the difference is within the margin of error of the MKT beta calculation. As was the case above, some combination of JMST and IGSB appears optimal for high marginal tax rate investors.
For those in lower tax brackets, some combination of FLRN and IBSB would be optimal, depending upon the desired level of duration risk (from the graph above).
iShares 1-5 Year Investment Grade Corporate Bond ETF (IGSB)
IGSB is an index fund based on the a market-value-weighted index of US dollar denominated, investment grade corporate debt with 1-5 year maturities (ICE BofA 1-5 Year US Corporate Index). Part of the reason that this particular short-term bond fund is able to eek out a slightly higher yield than other short-term bond ETFs is that it avoids the 0-1 Year maturity spectrum, which is used by both money market funds and ultra-short-term bond funds. A high level of demand depresses yields. (VCSH is based on a similar 1-5 year benchmark provided by Bloomberg Barclays, but despite a .01% lower expense ratio, has a slightly lower yield. Part of the explanation is that IGSB utilizes securities lending whereas VCSH does not.)
SPDR Bloomberg Barclays Investment Grade Floating Rate ETF (FLRN)
FLRN is an index fund based on an index of US dollar-denominated, investment-grade floating rate notes of less than five year’s maturity. (Bloomberg Barclays U.S. Floating Rate Note <5 Years Index.) As mentioned above, FLOT is based on the same index, however FLRN has a lower expense ratio by .05%. Also, although both funds utilize securities lending, FLRN gives 100% of the proceeds to the fund whereas FLOT keeps 20% for the management company and credits the fund for the remaining 80%.
JPMorgan Ultra-Short Municipal Income ETF (JMST)
JMST is an actively managed portfolio of US municipal bonds with a weighted average maturity of 2 years or less. Below-investment-grade debt exposure is capped at 10% of the portfolio. Thus, both interest rate risk and credit risk are low. Active management gives the fund flexibility not found with index funds, which must buy a pro-rata share of index constituents regardless of their creditworthiness.
For High (>=32%) Tax Bracket Investors: Buy a combination of JMST and IGSB
For IRA and Lower Tax Bracket Investors: Buy a combination of FLRN and IGSB