SGOV - An Investor's Guide To Ultra-Short Bond ETFs (Part 1)

2023-07-19 13:39:20 ET

Summary

• Ultra-short-term bonds have gained popularity due to recent interest rate hikes, offering low-risk, high-return investments.
• The article discusses 3 ultra-short-term bond ETFs with Buy ratings, addressing their pros and cons.
• Part one of this "guide" discusses SGOV, ULST, and VUSB.

Ultra-short-term bonds have become much more popular in the last year because of rising interest rates. They tend to be low-risk investments and typically also have a low yield, but because of the inverted yield curve, this is no longer the case. Investors should always be on the lookout for low-risk, high-return assets; right now, ultra-short-term bonds fit the bill.

Lately, I've covered quite a few ultra-short-term bond ETFs and have given many of them a Buy rating. Some followers asked me which short-term bond fund I believed was the best. I don't think there is a simple answer to this question. There are so many short-term bond ETFs; while they are similar, they all bring different things to the table. This is the first article of a 2-part "guide" to ultra-short-term bond ETFs. In this article and my next one, I'm going to cover a total of six ultra-short-term bond ETFs that I have Buy ratings on. I will introduce each ETF, address its pros and cons, and then give my opinion on what kind of investor the ETF is best suited for. At the end, I will give a "cheat sheet" that breaks down the three ETFs covered in this article at a glance. The current article (part one) covers SGOV, ULST, and VUSB.

SGOV

• 30-day SEC yield: 5.16%
• AUM: $11.70B
• Expense ratio: 0.07%
• Average maturity: 0.10 years

iShares 0-3 Month Treasury Bond ETF ( SGOV ) is an extremely low-risk ETF. It holds 0-3 month T-bills. It excludes inflation-linked securities, zero-coupon bonds, and cash management bills. The ultra-short T-bills SGOV holds are considered by most investors to be one of the least risky investment instruments offered. SGOV doesn't reinvest coupon payments; instead, the fund managers can choose to put the coupons into money markets, futures, options, swaps, or cash alternatives. These non-treasury assets will never account for over 10% of its AUM.

Pros

SGOV is so appealing to me and many other investors right now because of its impressive 30-day SEC yield of 5.16%. This is a very high yield considering that it's a practically risk-free investment.

The chart below shows SGOV's total return over the past year.

It's very easy to see how little volatility SGOV has. Even if we zoom out, SGOV remains very stable. The image below shows SGOV's total return since its inception.

Cons

While SGOV isn't volatile, its total return performance is heavily dependent on the fed fund rate. As the previous chart shows, from SGOV's inception to about July 2022, it returned almost nothing because rates were extremely low. When rates inevitably get cut, SGOV's yield will go down again and it could potentially start having very low returns. The information we have been given by the Fed on when to expect rate cuts suggests that it will be a couple of years until cuts start, meaning that this likely doesn't become an issue for a while.

Another downside of SGOV is that it has very low capital appreciation potential. When rates fall, bond prices rise. However, because SGOV holds very short T-bills, its price will barely appreciate.

Who is SGOV for?

SGOV seems the best choice for investors who want practically zero risk and are willing to give up capital appreciation potential for it.

ULST

• 30-day SEC yield: 5.34%
• AUM: $560M
• Expense ratio: 0.20%

• Average maturity: 0.7 years

SPDR SSGA Ultra Short Term Bond ETF ( ULST ) is an actively managed ETF that invests in mostly ultra-short investment-grade corporate and treasury bonds. Only about 15% of this ETF’s AUM is in treasuries, making it riskier and consequently giving it a higher yield compared to SGOV. The corporate bonds ULST holds are high quality, with about 55% of them being A-rated or higher. Another factor that causes ULST's yield to be higher is that it holds some longer-term bonds. About 25% of ULST is in bonds that have maturities of over a year.

Pros

While ULST is riskier and more volatile than SGOV, it still has low volatility. The image below shows the total return of ULST and BND , Vanguard's total bond market ETF, over the past year.

Along with this low volatility, ULST has a high current 30-day SEC yield of 5.34% and offers more capital appreciation potential than SGOV because it holds riskier and longer-term bonds. When rates get cut, ULST will appreciate.

Cons

As mentioned before, ULST has more risk than SGOV. While this gives it more capital appreciation potential and a higher current yield, it also increases default risk. If the economy enters a recession and it's more severe than most economists currently predict, the default risk of the corporate bonds that ULST holds may increase, causing ULST to suffer. I don't think this is likely, but it's certainly a possibility.

While an expense ratio of 0.20% isn't very high, especially for an actively managed ETF, it can start to really cut into gains after rates fall and ULST starts to have a low yield again.

Who is ULST for?

ULST seems the best choice for investors who are fans of actively managed ETFs and seek higher yields from a mix of treasuries and investment-grade corporate bonds, with a heavy emphasis on corporates. Investors should also be able and willing to tolerate more risk than SGOV.

VUSB

• 30-day SEC yield: 5.44%
• AUM: $3.67B
• Expense ratio: 0.10%

• Average maturity: 1.0 year

Vanguard Ultra-Short Bond ETF ( VUSB ) is another actively managed ETF that invests primarily in short-term corporate bonds, with only about 11% in T-bills. The corporate bonds VUSB holds are high quality, with about 62% of them being A-rated or higher. In contrast to SGOV and ULST, VUSB starts to push the boundaries of the term "ultra-short". The average maturity of the bonds VUSB holds is one year and about 40% of VUSB's holdings have maturity times over one year.

Pros

VUSB has the highest yield of the ultra-short bond ETFs on this list. It does this by adding risk to its portfolio through corporate bonds and longer maturity times. This also gives VUSB the most capital appreciation potential when rates get cut. While these cuts are perhaps a couple of years away, investors can benefit from the high current yield while they wait for rate cuts.

Cons

While VUSB is by no means a volatile asset, it is the most volatile on this list.

It has also underperformed in the past year, likely due to the impact of rising rates on its longer-term bond holdings. While past performance is no indication of future performance, it is hard to justify owning an actively managed fund that hasn't put up above-average numbers.

Just like ULST, VUSB holds a lot of corporates. If we enter a severe recession, default risk will increase.

Who is VUSB for?

VUSB seems the best choice for investors who are fans of actively managed ETFs and care more about yield and potential capital appreciation than low volatility.

Investor cheat sheet

Conclusion

While these ETFs, SGOV, ULST, and VUSB, are similar, they all bring different pros and cons to the table. When managing a portfolio, little differences can lead to a big change in results over time. I think almost every investor should own an ultra-short bond ETF in the current market environment because they have a great risk-reward ratio. Depending on your risk tolerance and outlook, it's up to you to pick which one. Part two will be out soon, and I will address three different ultra-short bond ETFs to complete the guide.

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