The purpose of this article is to evaluate the SPDR Portfolio Short Term Corporate Bond ETF (SPSB) as an investment option at its current market price. This is a fund that holds corporate bonds that are rated investment grade, which also have a remaining maturity between 1 – 3 years. I believe now is an opportune time for such an investment, for a reason reasons. One, the absolute yields offered by below investment grade bonds is declining, and investors have flocked to that asset class over the past few years. This makes the risk-reward proposition less attractive for lower quality assets right now. Two, the duration premium for longer maturity bonds has been narrowing, offering investors with less incentive to take on interest rate risk than in years past. Three, I believe investors are overestimating the possibility of Fed action on interest rates in the near term. While geo-political threats may force the Fed’s hand, I believe our current low rate environment and strong labor market will outweigh coronavirus concerns, and the Fed will maintain its current interest rate target. This is relevant because investors have begun to anticipate lower short-term rates, and that has driven demand for longer term assets. If that does not materialize, I see that trend reversing.
First, a little about SPSB. The fund’s objective is to “provide investment results that, before fees and expenses, correspond generally to the price and yield performance of the Bloomberg Barclays U.S. 1-3 Year Corporate Bond Index”. Currently, SPSB trades at $30.93/share and pays monthly distributions, which yield 2.74% annually. Last month, I wrote about the iShares iBoxx $ Investment Grade Corporate Bond ETF (LQD), where I laid out a case for moving up in credit quality over high yield corporate options. So far in 2020, this investment would have paid off fairly well, as it has shown a solid return since the year began, and it would has handily beaten SPSB’s performance as well, as shown below:
While I see merit in continuing to hold on to a fund like LQD, after the nice bump higher the fund has seen already in 2020 I am looking for ways to further limit downside risk going forward. While investment grade corporates are quite low on the risk scale, I am now not only moving up in credit quality, but also moving down in duration, to limit interest rate risk. To this point, I believe SPSB is a good option right now, and I will explain why in detail below.
Longer Durations Are Not Offering Much Compensation
To begin, I want to touch on the principle reason why I am covering SPSB right now. This relates to duration, or in the case of SPSB, the minimizing of it. Duration is a measure of interest rate sensitivity, related to the underlying maturity dates of the bonds in the portfolio. Simply, the longer the date to maturity, the longer the duration, and the more interest rate risk the investor is exposed to.
Of course, a longer duration is not necessarily a “bad” thing; it all depends on an investor’s individual objectives, as well as the interest rate forecast. Since the bond holder assumes more interest rate risk, given the longer term of the holding, they are being compensated with more interest, compared to shorter terms. This is a trade-off that investors should always be contemplating, and is not a new concept. However, I bring it up now because of what is going on in the bond market at the moment. While there are often times when investors are properly rewarded for taking on more interest rate risk, the current environment is offering little compensation for buying bonds with a longer duration. To gauge the relative compensation, a common metric is the “Sherman Ratio”, which measures the yield on a bond relative to its duration. When we look at the broader bond market right now, this ratio shows us that the amount of yield investors will receive for each unit of duration is close to the lowest level ever, as shown in the graph below:
As you can see, while investors are indeed earning a higher absolute yield for buying longer maturing bonds, the spread between the two is quite narrow. This means that, on a historical basis over the last decade, investors are earning quite a small premium for taking on additional interest rate risk.
Of course, there could still be an argument for buying in to funds with a longer maturity. Investors could still be willing to take on this risk in order to earn the extra yield, as small of a premium it may be. Using the example of LQD from above, that fund is currently yielding 3.21%, compared to SPSB’s 2.74%. When we tack on the stronger share price return, an investor could see merit to buying LQD. While I would not particularly find fault with this line of thinking, I believe the continued tightening of the duration premium spread shows that investors are taking on more risk than they might realize to earn that small amount of extra yield. It will not take much of an upward move in interest rates to wipe out the recent out-performance.
Fed Action, Are Investors Too Optimistic?
Expanding on the point above, I want to touch on another reason why investors may be looking at locking cash in to longer-term bonds. Clearly, interest rates are quite low right now, but there is room for them to drop further. If investors are anticipating the Fed will lower interest rates in the short-term, then longer-dated maturities will indeed make sense, especially compared to very short terms like what SPSB holds. Simply, interest rate risk works both ways. While the lower duration of SPSB helps buffer the impact of rising interest rates, it will work against the fund if rates were to decrease. Investors expecting this will want to lock in their cash at the higher absolute yields now, as SPSB would not only be yielding less now, it will see its bonds mature sooner and have to buy new bonds at prevailing (lower) rates.
And this does appear to the what investors are expecting right now, which helps explain LQD’s strong recent performance. With investors anticipating Fed action to lower rates in the year ahead, there has been a sharp uptick in demand for intermediate-term bonds. This has pushed down the yields on those assets, to the point where the yield curve has once again inverted. While important on its own, it is especially striking when we consider that this is a divergence to where we stood just over a month ago, as shown below:
Source: Charles Schwab
Clearly, investors are anticipating a rate cut, and that would work against SPSB right now.
With this backdrop, why would I be recommending SPSB? In fairness, while I can understand why investors may be anticipating Fed action, I personally feel it is a bit too optimistic right now. A spreading coronavirus is absolutely impacting global markets right now, and investors may be looking for the Fed to take action to combat this risk. Economic growth is expected to be impacted, especially in China – the worlds most important developing economy, but also across the world. However, I’m not sure the Fed cutting interest rates will do much to limit that risk, and the Fed has not indicated that they plan on doing so. Simply, while cutting rates can stimulate growth, they cannot cure a virus, and if investors are concerned about future growth because of the coronavirus, I do not believe the Fed cutting interest rates by .25 or .50 basis points will convince those investors to take on more risk.
Diving deeper in to this thought, the Fed did just meet at the end of January, and announced it would hold rates at current levels. While fears over the coronavirus have increased since then, the coronavirus was already making headlines at that time, so the Fed likely factored that risk in to its decision to keep rates steady. Furthermore, recent public statements by Fed officials since the January press conference have reiterated a neutral stance on interest rates, despite the coronavirus risks. Consider that just a few days ago, San Francisco Fed President Mary Daly spoke with reporters and noted she does not think the coronavirus would do anything “material” to the U.S. economy and also stated:
For right now, the way I see it is the cuts we have in place already, the accommodation, puts the US economy in a good place to weather the storm.
My takeaway here is that Fed officials clearly see their recent action as enough for now, confirming their previous inaction from last month. Further, the U.S. job market continues to look quite strong, which will also limit support from further Fed easing. Consider that labor force participation, especially among what are consider “prime age” workers, has been rising steadily, and sits at its highest level in a decade, as shown in the graph below:
To circle back to SPSB, I remain under the impression that there is little chance the Fed will cut interest rates over the next few months. This limits the downside potential to SPSB. If my prediction is accurate, it will likely cause investors to rotate out of longer duration bonds, as they seem to have been moving in to them in anticipation of Fed action that I feel may not materialize.
Why I Favor Investment Grade Credit Right Now
My final points will discuss why I favor investment grade corporate bonds right now. This is support for buying SPSB, but it also has a broad application for investors considering other fixed-income products with investment grade exposure. While high yield corporate bonds did have a stellar 2019, the gains in that sector are making new positions much less attractive, in my view.
My point here is that, as the value of the bonds in below investment grade assets have risen, the yields being offered in the space continue to shrink, to the point where I am not seeing much compensation for taking on that credit risk. To illustrate, consider the yields offered from below investment grade corporates are low on a historical basis. In fact, if we look at BB-rated corporate bonds, which are one step below investment grade, the yields on the bonds sit at levels not seen in decades, as shown below:
Of course, on an absolute level, junk bonds are indeed offering more income, but investors have to consider if the small amount of yield spread is worth the extra credit risk. I personally do not think so.
Furthermore, aside from the yield spread, the total return premium for buying junk bonds is also narrowing quickly. As I noted, junk bonds would have been a winning asset class last year, as the sector saw strong gains, especially compared to investment grade debt. In fact, the total return premium for buying junk over investment grade bonds rose sharply recent years. However, recent premium spreads show junk has seen this out-performance narrow quite quickly in the short term, as shown below:
While this spread has been positive for riskier assets in the last few years, the above graph also shows that the total return premium has narrowed sharply to round out last year and start off 2020. With yields compressed across the junk space, and investors looking to take some risk off the table after a strong year, the attractiveness of the junk bond sector is really being minimized.
This is relevant for SPSB because, while the yield is certainly not “high”, the fund is made up almost exclusively of investment grade corporate bonds, as the chart below illustrates:
Source: State Street
With yields and return premiums narrowing among lower quality asset classes, I see investment grade credit as a smart place to be right now. Credit risk is minimized and the yield, while not overly impressive, is not much less than what investors would be getting if they moved further down the quality ladder.
SPSB is a great option for investors looking to limit both credit and interest rate risk. The fund is comprised of short-term, quality corporate bonds, and should provide a steady level of income while investors wait for better opportunities to present themselves in both the equity and fixed-income markets. With investors being offered little compensation, on a historical basis, for taking on longer durations or lower credit ratings, I see investment grade bonds as the best place to be. Therefore, I am considering a position in SPSB, and would recommend investors give the fund some consideration at this time.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in LQD, SPSB over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.