Contributor, Benzinga
April 3, 2023

The traditional 60/40 rule involves investing 60% in stocks and 40% in bonds. The stocks drive returns, while the bonds provide protection. For many decades, this combination worked well as interest rates fell and stayed low.

Fast forward to 2022, where aggressive interest rate hikes caused bonds to post their worst year in four decades. However, one category of bonds survived: low-duration fixed income. 

After being ignored for years due to low yields, these assets finally found a place in many investors' portfolios thanks to their interest rate immunity.

To invest in low-duration ETFs, investors can use exchange-traded funds (ETFs) that hold a basket of them. However, these ETFs come in many varieties, with different objectives and holdings. Therefore, it's important to understand how they work and what they do before you buy.

Here's all you need to know about investing in low-duration ETFs. 

What Are Low-Duration ETFs?

Duration refers to the interest rate sensitivity of a bond's price. Let's walk through the following hypothetical scenario.

Imagine that you purchased a $100 bond maturing in 10 years, paying an annual fixed coupon of $4, or 4%. If interest rates shot up to say 5%, your bond is suddenly unattractive. After all, who would buy your bond that yields 4% when they can buy new ones that yield at least 5%?

Your bond yield must now increase to match that 5%. Your $4 coupon payment for a $100 bond is 4%, which is too low. However, if the bond price falls to $80, then your $4 coupon now corresponds to a 5% yield, which is competitive with the current interest rate. Unfortunately, your bond is now trading at $80.

If you sell the bond before it matures, then you lock in a loss. However, if you hold the bond until maturity, you're guaranteed your $100 back, plus the usual $4 per year. This is a hypothetical example, and the real math is much more complicated. However, it can be summed up as:

  1. When interest rates rise, so do bond yields.
  2. Bond prices are inversely related to bond yields.
  3. Therefore, when interest rates (and thus bond yields) rise, bond prices fall.

Duration is really just a metric for understanding the magnitude of this relationship. As a rule of thumb, for every 1% increase in interest rates, a bond's price will decline 1% for every year of duration. 

Assume a hypothetical bond with a duration of say, 20 years, which is typical for long-term bonds. If interest rates increased by 1%, this bond would be expected to decrease by approximately 20%, all else being equal.

The calculation for bond ETFs is a little different as they hold a portfolio or ladder of bonds with different maturities. When assessing bond ETFs for duration, look for the effective duration or average duration metric to get an idea of its overall interest rate sensitivity. 

A low-duration ETF is one that possesses a low duration. There's no hard-and-fast rule for this, but an ETF with a duration of three years or less can be considered low. As noted earlier, these ETFs are the most resilient when interest rates rise. 

Types of Low-Duration ETFs

Low-duration ETFs come in a variety of forms. Investors can distinguish them based on the issuer – who created and sold the bonds in the first place. Let's look at some common types of bonds with specific low-duration ETF examples for each:

  • Government: The U.S. government often issues Treasury bonds. ETFs holdings with less than three years to maturity are often deemed low duration. The ones with the lowest durations often hold Treasury bills or T-bills with less than a year until maturity. They can also hold short-term Treasury-Inflation Protected Securities (TIPS) or floating rate notes. To identify these ETFs, look for the terms "ultra-short," "short," "1-3 year" or "floating rate" in their names. ETF examples include the iShares 1-3 Year Treasury Bond ETF (NASDAQ: SHY), the Vanguard Short-Term Treasury ETF (NASDAQ: VGSH), the SPDR Bloomberg 1-3 Month T-Bill ETF (NYSEARCA: BIL), the Vanguard Short-Term Inflation-Protected Securities ETF (NASDAQ: VTIP) and the WisdomTree Floating Rate Treasury Fund (NYSEARCA: USFR). 
  • Corporate: Public companies issue short-term bonds or promissory notes. These tend to have a higher risk of default than government bonds but pay higher yields. You can identify these ETFs the same way as government ones, but with the words "corporate" or "income" in their name. Examples include the JPMorgan Ultra-Short Income ETF (NYSEARCA: JPST), the Vanguard Short-Term Corporate Bond ETF (NASDAQ: VCSH) and the Invesco Ultra Short Duration ETF (NYSEARCA: GSY).
  • Aggregate: Some low-duration ETFs combine government and corporate bonds in various proportions. Examples include the Vanguard Short-Term Bond ETF (NYSEARCA: BSV) and the PIMCO Enhanced Low Duration Active Exchange-Traded Fund (NYSEARCA: LDUR). 

Benefits of Low-Duration ETFs

Low-duration ETFs have become increasingly popular in recent years due to the following characteristics:

  • Low interest rate risk: Low-duration ETFs, especially ultra-short ones with durations of under one year, suffer the least when interest rates rise.
  • Low market risk: Low-duration ETFs, especially ones holding high-quality Treasury bonds, can maintain their value when the stock market crashes.
  • Higher yields: When the yield curve is inverted, low-duration ETFs can pay yields higher than their longer-duration counterparts. 

Drawbacks of Low-Duration ETFs

Despite their recent popularity, there are still a variety of reasons why some investors may want to avoid low-duration ETFs:

  • Inflation risk: Over long periods of time, the yield from low-duration ETFs may not keep up with inflation rates.
  • Low yields: Most of the time, low-duration ETFs tend to pay lesser yields than their longer-duration cousins, assuming credit quality is similar. 
  • Low returns: Bonds generally have lower expected returns than stocks, and low-duration ETFs have the least in the bond category.

Compare Low-Duration ETF Brokers

Investors looking to research and choose the best low-duration ETFs can use Benzinga to compare the available selections available on the market. Not all low-duration ETFs indicate they are in their name, so it's important to carefully read their ETF factsheet and prospectus to see if their methodology is truly low duration. Here is a list of brokers that support low-duration ETF trading and offer research tools to help investors select the right one.

Frequently Asked Questions

Q

Are low-duration ETFs a good idea?

A

A low-duration ETF is a good idea for older, low-risk investors who require the safety of principal and low volatility. These investors often hold a substantial portion of bonds for safety and income. By converting a portion of this to lower durations, these investors can hedge their portfolios against the risk of rapidly rising interest rates. When this occurs, longer-duration bonds can lose substantial value, nearly as much as stocks in some cases. However, younger, risk-tolerant investors in the accumulation phase will probably find low-duration ETFs unsuitable for their needs because of a lack of growth potential. 

Q

Are low-duration ETFs a safe investment?

A

Low-duration ETFs are considered safer investments compared to most stock and bond ETFs but are not entirely risk-free. While they are somewhat immunized to interest rate changes, they can still lose value depending on their underlying asset. In particular, investors should watch out for low-duration ETFs that hold bonds with poor credit quality, such as high-yield “junk” bonds. Another hidden risk of low-duration ETFs is their weakness during inflationary periods. If prices rise suddenly and remain elevated for a long-time, they can easily drown out the yield from a low-duration ETF, while other asset classes like stocks could still produce a positive nominal (after-inflation) return. 

About Tony Dong

Tony Dong, MSc, CETF®, is a seasoned investment writer and financial analyst with a wealth of expertise in ETF and mutual fund analysis. With a background in risk management, Tony graduated from Columbia University in 2023, showcasing his commitment to continuous learning and professional development. His insightful contributions have been featured in reputable publications such as U.S. News & World Report, USA Today, Benzinga, The Motley Fool, and TheStreet. Tony’s dedication to providing valuable insights into the world of investing has earned him recognition as a trusted source in the finance industry. Through his writing, he aims to empower investors with the knowledge and tools needed to make informed financial decisions.