EMNT - ICSH: STIP Looks More Attractive If You're Looking To Park Cash

2023-03-24 09:00:23 ET

Summary

• Adding duration and inflation protection are two important reasons to consider switching from the iShares Ultra Short-Term Bond ETF to the iShares 0-5 Year TIPS Bond ETF.
• STIP has a higher effective duration, a better credit quality, but also higher volatility compared to ICSH.
• We believe STIP is currently more attractive than ICSH due to its higher expected returns and better credit quality.

With the Federal Reserve hinting that they are getting close to the end of this interest rate tightening campaign, it probably makes sense to add a little bit of duration to fixed income investments. That includes short-term bond ETFs such as the iShares Ultra Short-Term Bond ETF ( ICSH ). We believe one good replacement option, for investors willing to add some duration to their short-term bond ETFs, is the iShares 0-5 Year TIPS Bond ETF ( STIP ), which currently offers a very attractive real yield of ~2.22%.

Adding duration and inflation protection would be the two main reasons to consider switching from ICSH to STIP, but there are a number of additional advantages that STIP has over ICSH as well as some additional risks to consider. Let's compare the two in detail, but first, let's have a look at the total return investors would have gotten the last five years in each of these ETFs. The total return for STIP has been significantly higher, but with a lot more volatility. This is not surprising given STIP's higher Beta, which currently stands at ~0.12 compared to ICSH's ~0.03.

Expected Returns

A few key indicators provide an idea of the types of returns these funds generate. We like looking at the 30 day SEC yield which gives an idea of the current dividend yield, which in STIP's case is ~6.5%, while ICSH's is ~4.7%. But what gives an even better idea of the longer term expected returns is the real yield at which STIP is trading, which is currently ~2.2%. The real yield is the weighted average yield to maturity of the fund adjusted to remove the effects of inflation. In other words, STIP is priced to deliver roughly 2.2% plus inflation.

We could compare this expected return to ICSH's average yield to maturity, which stands at ~5.2%. We believe that in a highly inflationary environment like the current one a ~2.2% real return is much more attractive than the ~5.2% ICSH offers.

Another important factor to consider is that STIP has a much higher effective duration at ~2.4 years, compared to ICSH's ~0.4 years. This is an advantage if the interest rate hiking cycle is almost complete, since it means it can maintain the high rates for longer once interest rates start decreasing. Conversely, if there are many interest rate hikes left in the cycle, a shorter duration fund is likely to perform better. Given that interest rate increases are starting to have a negative effect on financial stability, and inflation appears to be stabilizing, we believe we are relatively close to the end of the interest rate hiking cycle.

ESG Characteristics

One big disappointment we have with ICSH is that it is now investing in controversial sectors. As can be seen below, it now has some assets invested in tobacco, nuclear weapons, and controversial weapons. For investors wanting a similar ultra short-term bond fund to ICSH, but with better sustainability characteristics one option to consider is the PIMCO Enhanced Short Maturity Active ESG ETF ( EMNT ).

Credit Quality

There has also been a meaningful deterioration in the credit quality of the ICSH ETF since the last time we covered it. Last time it had 21.9% of the ETF invested in BBB rated bonds, and that has significantly increased to 29.3%. Given the current increasing risks of financial instability, we don't think it is the right time to reduce credit quality. By comparison an ETF like STIP is mostly invested in government bonds, and therefore has an excellent credit quality.

Risks

ICSH and STIP have different risks that investors need to consider. With STIP, it is important to remember that it has a higher effective duration, and therefore would be significantly more affected by increased interest rates. Its returns are also influenced by the inflation rate, therefore more difficult to estimate. STIP also has much higher volatility compared to ICSH and other ultra-short term bond funds.

With ICSH, there is higher credit risk and no inflation protection. For longer-term investors we believe the lack of inflation protection in the current environment is a very important risk to consider, as purchasing power erosion can be significant.

Conclusion

We believe investors wanting to invest in short-term bond ETFs should consider STIP in the current inflationary environment. While the bond has a higher effective duration, this could turn out to be an advantage if the interest rate hiking cycle is almost complete. While there are important differences to consider between the two ETFs, we believe STIP is currently more attractive. We are also disappointed with ICSH's sustainability and credit quality deterioration. Importantly, given the current inflationary environment we believe STIP's current real yield of ~2.2% to be quite attractive.

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