From May 1, 2013 to July 5, 2013, the yield on 10-year Treasury bonds jumped from a paltry 1.66 percent to 2.75 percent. While many have been expecting rates to rise as a result of all the quantitative easing, I admit the recent spike caught me a bit off guard.
The snail’s pace of improving economic conditions and the constant double-speak from the Fed had put me in a bit of a lull. Not anymore.
In the past, I wrote about different options for curtailing interest-rate risk with bond ETFs. Bank loans, floating rate notes, active strategies and soon-to-be-closed target-date funds have all made the rounds. After a rate jump of more than 1 percentage point in just two months, I decided to look back and see which of these strategies fared best.
I was a bit surprise to find that none of the previously mentioned options fared as well as an often-overlooked type of ETFs that I have only mentioned in passing before:variable rate demand obligations (VRDOs).
VRDOs are municipal bonds with resetting interest rates. These bonds typically have long-dated maturities, but interest rates reset on a daily, weekly or monthly basis, and investors have the option to put the bonds back at par.
Two funds target the space:the PowerShares VRDO Tax-Free Weekly Portfolio (PVI) and the SPDR Nuveen S'P VRDO Municipal Bond ETF (VRD). Both were part of a select group that eked out small gains at a time when almost all the other strategies posted losses.
Of the two funds, PowerShares’ PVI sports a higher expense ratio (25 basis points versus VRD’s 20 basis point), but as the first to market, has remained the preferred choice for investors. VRD has accumulated almost $225 million in assets under management and more than $3 million in average daily volume.
The fact that these funds performed exactly as billed wasn’t that shocking. However, the fact that they were the best-performing funds among the short- and ultra-short-term bond ETFs was definitely a bit of a surprise.
Since the short end of the curve remained virtually unchanged during the time 10-year Treasurys shot up, duration differences between these funds and some of their short-dated competitors shouldn’t have played much of a role in performance. Still, having the shortest durations across all fixed-income ETFs didn’t hurt their cause.
The differences I suspect came because of changes to credit spreads; specifically, option-adjusted spreads (OASs).
Over the same time that rates rose, credit spreads widened. For example, the OAS on the Barclays US Corporate Duration '1 Index jumped from 100 basis points to 360 basis points between May 1 and July of this year. High yield also took its lumps, with the OAS on the underlying index for the SPDR Barclays Short Term High Yield Bond ETF (SJNK), the Barclays US High Yield 350mn Cash Pay 0-5 Yr 2% Capped Index, up over 100 bps.
As such, investors seeking yield and interest-rate shock protection in products like the PowerShares Senior Loan Portfolio (BKLN); SJNK; the iShares Floating Rate Note ETF (FLOT); and the Pimco Enhanced Short Maturity ETF (MINT) were reminded of an important lesson:Credit spreads aren’t static.
Just because interest rates move against you doesn’t mean credit spreads won’t widen at the same time.
Muni spreads also ticked up, but the ability to get par back at the next reset limits the credit risk of the VRDO securities and makes them less susceptible to changes in credit spreads.
At the same time, the VRDO ETFs performed slightly better than the SPDR Barclays 1-3 Month T-Bill ETF (BIL) because there’s still an element of credit risk that must be compensated with a slightly higher yield.
These funds aren’t without issues, as liquidity in the VRDO market is much weaker than in T-bills. As a result, these funds can face the same premium/discount issues that have been thoroughly dissected by many of my colleagues over the past few weeks.
As always, “know what you hold and the risks it involves” remains the mantra to live by.
Nonetheless, anyone looking for safety in the sea of interest and credit-risk uncertainty should include VRD and PVI in their consideration.
At the time this article was written, the author held no positions in the securities mentioned. Contact Gene Koyfman at firstname.lastname@example.org.
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