Fed Rate Hike Boosts Bond ETFs

MarketsETF Trends

This article was originally published on ETFTrends.com.

The recent rate hike by the Federal Reserve is seen as boosting the attractiveness of short-term bonds and the related bond ETFs, including the iShares Short Treasury Bond ETF (NASDAQ: SHV).

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SHV tracks the ICE U.S. Treasury Short Bond Index, which is comprised of U.S. Treasury obligations with a maximum remaining term to maturity of 12 months. Short-term Treasury yields are highly sensitive to changes in the Federal Reserve’s interest rates. The Fed hiked rates three times last year and is expected to raise interest rates several more times this year.

“We see short-term U.S. debt offering relatively compelling income, with limited downside risk, now that market participants have greater confidence in the Fed’s planned normalization path,” said BlackRock in a note out Friday. “In most of the post-crisis normalization period, the bond market significantly discounted Fed expectations for the pace of normalization.”

Playing Catch Up

Rising short-term interest rates boost the allure of ETFs such as SHY. When U.S. interest rates were hovering around record lows, the yields on funds like SHY were not notable, but today SHY has a 30-day SEC yield of 1.57%. The fund has an effective duration of just 0.39 years. Duration measures a bond's sensitivity to interest rate changes.

“The market has now caught up with the Fed’s view, with rising short-term interest rates reflecting this greater confidence,” said BlackRock. “Market participants previously had good reason to be skeptical. 2017 was the only year the Fed delivered on its promised pace of normalization. But current economic tailwinds – tax cuts and plans for more government spending – suggest the central bank is poised to extend that recent track record.”

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Technical factors like higher U.S. Treasury bill issuance due to a rising federal budget deficit are also adding to the factors pushing short-term yields higher. As a result, short-term Treasuries may provide positive real yields for the first time since the financial crisis, with income sufficient to offset inflation.

“Lost revenues from tax cuts, twinned with greater government spending, mean more borrowing to fund deficits,” according to BlackRock. “We project the U.S. deficit to hit 5.7% of gross domestic product (GDP) 2019, the highest since 1960, outside of the 2008 crisis aftermath. The deficit spike comes even as the jobless rate drops to multi-decade lows – an unprecedented disconnect.”

For more information on Fixed-Income ETFs, visit our Fixed-Income category.

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