ISTB - ISTB: Short-Term Bonds Are Useful Under Certain Conditions

Summary

• The iShares Core 1-5 Year USD Bond ETF holds treasuries and investment-grade corporate bonds.
• Its 2% yield may not be particularly appealing for income seekers.
• However, it is useful under certain conditions, for income, diversification, and hedging purposes, but wait for a better margin of safety.
• In addition to interest rate risks, ISTB can also be volatile due to its emerging market holdings which include some of Adani's debt.
• The underlying theme of this thesis is to explore options available for those who are currently long cash.

The year has changed, but the one big question on investors' minds lingers on, namely whether they should still be in cash or consider other options like equities or fixed income. For this thesis, I cover short-term bonds and out of the list below, I choose the iShares Core 1-5 Year USD Bond ETF ( ISTB ) as it has the highest market capitalization, and by far. Its expense ratio is also the lowest at 0.06%.

The aim of this publication is to assess whether it makes sense to invest in ISTB at this stage of the monetary cycle when the Fed has to further raise interest rates, on the one hand, to combat high inflation while trying to avoid triggering a recession on the other.

I start with the latest Fed's actions and the impact on bonds.

Interest Rates Likely to Continue their Ascent

First, the 25 basis points rate hike we saw in January this year was inspired more by the prospect of lower inflation and a Fed pivot, or change to a more dovish tone. However, this perspective is now behind us and we are left with high-interest rates which are at more than a decade high as pictured below.

These have in turn increased borrowing costs significantly, which should normally have dampened business appetite at the point of lowering demand for goods and services, but signs of persistently high inflation remain as I elaborate upon below.

Hence, the CPI (Consumer Price Index), PPI (Producer Price Index) data, and personal consumption expenditures (PCE) were all higher than expected in January. There was also a better-than-expected PMI (Purchasing Managers' Indices) that came in above consensus. These were accompanied by decreasing jobless claims.

At the same time, various officials have thrown their weight behind Fed Chairman Jerome Powell to convey a more hawkish tone. Thus, the New York Fed President John Williams reportedly commented in the final week of February, that both demand and supply chain woes could keep prices from falling as quickly as expected.

Two other Fed Presidents, James Bullard, and Loretta Mester have put forward the rationale for a 50 basis-point interest-rate hike. Indeed, the minutes from the last meeting of the Federal Open Market Committee suggest that the Fed will continue to raise rates in its resolve to fight inflation, in sharp contrast with the January meeting where it was more about delivering two 25 basis points increments and pausing.

Interest Rate Risks

Now, rising interest rates are not favorable to bonds, be they long or short-duration ones as seen during 2022, which encapsulates a period that saw the U.S. central bank hiking rates at a pace not seen in more than a decade. This underperformance for both ISTB (in deep blue) and the long-duration bonds of the iShares Core 5-10 Year Bond ETF ( IMTB ) are illustrated in the charts below. However, there is a difference between the degree of underperformance with IMTB's orange chart suffering from a one-year downside of 11.57%, which is worse than either ISTB or the S&P 500 in pale blue.

Looking in the rear mirror and as illustrated in the chart below, during the March 2020 Covid crash, bonds recovered faster than equities, or within only two months. Now, part of the reason is the Fed cut short-term interest rates to zero as per the Fed Fund rates chart above, in turn causing bond yields to go down, conversely propelling up their prices. This is all due to the inverse correlation between bond prices and their corresponding yields.

This time around, with high inflation likely to be sustained in 2023, things may be different in case the market crashes due to fears of the economy falling into recession. For this matter, borrowing costs that are already high could deal a fatal blow to investors' risk appetite or liquidity risks may emerge as corporations find it more difficult to get access to finance.

Looking specifically at bonds, the Fed may not be in a position to completely reverse monetary policy to become accommodative. Hence interest rates may not go down rapidly enough for yields to fall at the same pace as in 2020. This implies that after a potential market crash, bond prices may take more time to recover.

Still, as per its historical performance, ISTB should not be impacted to the same degree as equities or longer-dated bonds. As a matter of fact, the longer the duration of a bond which is just a debt instrument used to raise capital, the more the repayment time. This implies that a long-term bond is riskier for the lenders or bond purchasers relative to a shorter-duration one.

Consequently, for people contemplating to be long cash, bonds are not completely safe, when compared to an insured savings account or money market funds, but, it all depends on their investment objective and the type of fixed income being contemplated.

ISTB's Holdings

For its part, ISTB includes government treasuries, at 47% of its overall exposure, plus corporate bonds as pictured below. Furthermore, the ETF seeks to track an index composed of U.S. dollar-denominated bonds that are rated either as investment grade or high yield. As a result, the fund provides targeted access to government, corporate, securitized, as well as emerging market bonds.

In this respect, the bond fund has exposure to assets from China, Turkey, India, and many other countries including some from the Adani group of companies, but with less than 0.03% of combined exposure. Now, with the Fed likely to raise rates further, the dollar may again gain strength as it did last year and at one point, it had surged by nearly 20% as I have explained in a recent thesis. This makes the task of fighting inflation harder in emerging markets, while at the same time adversely impacting individual countries' balance of payments as they have more exposure to the greenback compared to more developed markets.

However, the fact that ISTB focuses on investment grade bonds with 60.81% of its assets bearing a AAA credit score is synonymous with high quality. In addition, it holds 5,518 bonds which confer to its low concentration risks.

Consequently, this short-duration fixed income can be useful, but, I further elaborate under what circumstances.

Usefulness at the current Juncture

In this respect, with the fight against inflation likely to take a long time, interest rates will continue to rise in turn increasing ISTB's dividend yields as shown in the orange chart below.

Conversely, the ETF's share price should suffer, but, probably not to the same extent as in 2022 when there were four 75 basis point hikes whereas now it is more question about 50. For this purpose, momentum indicators point to some resistance at the $45.7 level, which is 0.77$ below the current share price of $46.47. Thus, investors can wait for some further downside to benefit from a better margin of safety.

Going back to the above chart, the growing dividends paid on a monthly basis can become a useful argument when contemplating an investment at the current juncture. Hence, instead of being all in cash or making an investment as invoked during the introduction, with the average savings account in the U.S. proposing an interest rate of 0.35% APY (Annual Percentage Yield), putting some money into ISTB's short-dated bonds with its 2% yield start to make sense.

Conclusion

Therefore, investing some money in ISTB's short-term bonds is useful as it allows for more returns than just holding cash or venturing into online savings accounts which offer rates varying from 2% to 4% . Along the same lines and talking diversification, the iShares ETF helps to hedge your portfolio of equities and longer-duration bonds.

Finally, due to exposure to emerging market debt, do expect more volatility than bond funds holding exclusively U.S. treasuries or corporate bonds.

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