Danger Ahead for Short-Term Bond ETFs?

From David Fabian: In 2014, the SEC legislated new guidelines concerning the function of money market funds. These rules will finally take effect in October 2016 as a response to the liquidity issues that several banks and fund companies experienced during the 2008-2009 financial crisis.

At the core of the new rulebook is a stipulation that certain institutional money market funds will now be subject to a floating net asset value (NAV). This removes the prior “stable value” of a $1.00 NAV that has been the standard for decades. During times of stress, these subjected funds can also charge redemption fees to help stem a potential outpouring of assets.

Investopedia did an excellent recap that is available here for those who want further specifics on the new money fund rules. It should also be noted that retail investor money market funds are not subject to these same restrictions.

Whenever I hear “institutional investors,” I think big money. Billions of dollars reside in these money market accounts from the likes of hedge funds, endowments, foundations, charitable organizations, sovereign wealth funds, and other major investors.

The primary reason they would have cash parked in a money market fund is for stability and failsafe liquidity. When those absolute guarantees are taken away, it is likely that they will look for alternative options to park their cash for both short and intermediate-term needs.

This opens the door for those billions of dollars in institutional money funds to seek out low-cost, diversified, transparent, and flexible vehicles like exchange-traded funds. There are several options that exist in both the ultra-short term and short-term bond category that may pique the interest of money managers.

For instance, the iShares Short Treasury Bond ETF (NYSE:SHV) is the largest ultra-short term bond ETF with $3.3 billion in total assets. This fund invests in a basket of Treasury bonds that mature in less than one year. The current effective duration of SHV is 0.38 years, meaning it has very low sensitivity to changes in interest rates. SHV currently offers a minimal expense ratio of 0.15% and pays a 30-day SEC yield of just 0.27%.

Another option in this category that takes a more active approach is the Guggenheim Enhanced Short Duration ETF (NYSE:GSY). This fund seeks to hold a diversified mix of corporate and treasury bonds with an average duration of less than one year. GSY currently sports a 30-day SEC yield of 1.15% and a net expense ratio of 0.28%.

The addition of corporate bonds introduces a marginally higher credit risk, which is to be expected with the pickup in yield above a Treasury-only fund like SHV. Furthermore, GSY has the ability to pivot the portfolio based on both quantitative and qualitative factors that may appeal to active management enthusiasts.

There is also a tremendous menu of options available in the short-term bond category. ETF.com lists 57 funds that include both domestic, foreign and global fixed-income exposure. The top 15 short-term bond ETFs all have over $1 billion in assets, making this well-traveled territory for conservative yield seekers.

The largest passive index offering is the Vanguard Short-Term Bond ETF (NYSE:BSV) with $18 billion in assets and a minimal 0.09% expense ratio. BSV covers a broad index of investment-grade bonds with a yield of 1.06% and average duration of 2.7 years.

The iShares 1-3 Year Credit Bond ETF (NYSE:CSJ) is another popular option in the low duration spectrum as well. CSJ offers a yield of 1.21% and an effective duration of 1.93 years. All holdings in this fund are rated investment grade and above.

The Bottom Line

An influx of capital from institutional money market funds to short-term bond ETFs will likely create beneficial effects for all investors through higher volume and tighter trading spreads. These are the hallmarks of liquid markets.

Furthermore, these tools can be used to remove the uncertainty of redemption fees and enhance yields for institutional portfolios. The potential for floating net asset values in institutional money market funds likely has many managers on edge as they contemplate the risks and rewards of protecting their short-term capital.

Nevertheless, it’s critical to note that all of the ETFs mentioned above are susceptible to some level of interest rate and/or credit risk.

This article is brought to you courtesy of FMD Capital.