Short Term Bond ETFs

Bond investing is a bit like the story of Goldilocks and the Three Bears. Investors may have to try a variety of bonds before they find one that is just right for them in terms of maturity and credit quality. 

This article discusses the former – maturity. Just like how Goldilocks had to try three different beds, bonds usually come in three categories of maturities as well – short-term, intermediate-term and long-term, each with its own pros and cons.

Short-term bonds are the ones occupying investor attention right now thanks to rising interest rates and an inverted yield curve. Because of these variables, short-term bonds have been one of the more resilient fixed-income assets throughout 2022 and are now paying respectable yields.

However, before you buy a short-term bond — usually via an exchange-traded fund (ETF) —  it’s a good idea to fully understand the risks and rewards of this unique asset class. Here's what you need to know before you buy a short-term bond ETF.

What Are Short-Term Bond ETFs?

A short-term bond ETF is an open-ended fund that holds a portfolio or ladder of bonds with maturities ranging from one to five years. However, unlike individual bonds, short-term bond ETFs do not mature — their portfolio of bonds is constantly churned to buy and sell bonds to maintain the ETF's target maturity. 

Shares of short-term bond ETFs trade on exchanges with their own ticker symbol, unlike individual bonds that trade over the counter. In addition, most short-term bond ETFs pay out interest on a monthly basis, compared to individual bonds that usually pay semi-annually. 

To identify a short-term bond ETF, investors can look at the ETF's homepage or its factsheet for the weighted average maturity metric or similar. This term tells you the average overall maturity of all the underlying bonds in the ETF, weighted by each bond's proportion.

Another metric to pay attention to is duration, which can be found as effective duration or average duration. This metric tells you how much a bond ETF's price can be expected to move given a 1% change in interest rates. As a rule, bond prices are inversely related to interest rate movements.

For example, a 1% increase in interest rates would cause a short-term bond ETF with an average duration of 2.67 years to lose 2.67% in value, all else being equal. The opposite would occur if interest rates fell. Keeping an eye on duration is a good way to assess the interest rate risk of a short-term bond ETF. 

While short-term bond ETFs generally have average maturities of between one to five years, there's no hard and fast rule for duration. In general, most short-term bond ETFs will have durations of three years or below, but this can change. 

To identify short-term bond ETFs, investors can look for words in their names like short-term, ultra-short or low duration. However, it's important to look closely at the ETF's factsheet and prospectus to truly understand what it does and what it holds. 

Types of Short-Term Bond ETFs

Short-term bond ETFs are also a bit like ice cream — they may share the same underlying ingredients such as maturity and duration but can vary in terms of flavor. In this case, flavor refers to the issuer of the bond, which is the entity that sold it in the first place. Some common types of short-term bond ETFs and specific ETF examples include:

• Treasury: Short-term bond ETFs can hold U.S. government-issued Treasuries with less than one to three years in maturity. These bonds have a low risk of default, which combined with their low duration makes them a great asset to hedge equity and interest rate risk. However, they don't pay great yields. With low risk comes low return. To identify these ETFs, look for the terms Treasury, government or T-bill in their name. ETF examples include the iShares 1-3 Year Treasury Bond ETF (NASDAQ: SHY), the Vanguard Short-Term Treasury ETF (NASDAQ: VGSH) and the SPDR Bloomberg 1-3 Month T-Bill ETF (NYSEARCA: BIL).

• Corporate: Companies can also issue short-term bonds to finance their operations. Compared to government Treasuries, corporate bonds have a higher risk of default but make up for it with greater yields. If your goal is income over safety, then an ETF holding these bonds could be a good pick, especially if you want to reduce interest rate risk. These ETFs usually have the words corporate or income in their name. Examples include the Vanguard Short-Term Corporate Bond ETF (NASDAQ: VCSH).

• High yield: Some short-term bond ETFs hold corporate bonds with non-investment grade credit ratings. These are also known as junk bonds. Compared to regular corporate bonds, junk bonds are much riskier in terms of default but can pay high yields. Investors looking for a low interest rate sensitivity holding with high yields can pick a short-term high-yield bond ETF if they do not mind the credit risk. Examples of these ETFs include the iShares 0-5 Year High Yield Corporate Bond ETF (NYSEARCA: SHYG), and the SPDR Bloomberg Short Term High Yield Bond ETF (NYSEARCA: SJNK). 

• Aggregate: The most common type of short-term bond ETF is one that combines government and investment-grade 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 Short-Term Bond ETFs

Short-term bond ETFs can fill an important niche for a safety-oriented investment portfolio. Some of the reasons why investors may prefer a short-term bond ETF include:

• Low interest rate risk: Short-term bond ETFs with low durations tend to lose the least value when interest rates rise. 
• Low market risk: Short-term bond ETFs with high credit quality, such as those holding Treasuries tend to be much safer when stock markets crash. 
• Higher yields: When the yield curve is inverted, short-term ETFs can pay yields higher than their long-term counterparts. 

Drawbacks of Short-Term Bond ETFs

Like all investments, short-term bonds have their own unique risks and drawbacks that may make them unsuitable for some investors. These include:

• Inflation risk: Over long periods of time, the yield and total returns of short-term bond ETFs may not keep up with inflation rates.
• Low yields: Assuming credit quality is similar, short-term bond ETFs usually have lower yields than their long-term counterparts, as investors are generally compensated to take on greater interest rate risk.
• Low returns: Compared to other asset classes like stocks, short-term bond ETFs tend to have much lower expected returns because of the lack of a market risk premium. 

Compare Short Term Bond ETF Brokers

Investors looking to research and choose the best short-term bond ETFs can use Benzinga to compare the available selections available on the market. Here is a list of brokers that support short-term bond ETF trading and offer research tools to help investors select the right one.

Frequently Asked Questions