Investors Are Snubbing One of the Best Hedges Against Soaring Yields

With 10-year Treasury yields racing to a nearly 10-month high, investors may be kicking themselves for shunning the fixed-income products that could’ve offered shelter from this rates storm.

The three-month moving average of weekly flows into the iShares Short Maturity Bond exchange-traded fund (NEAR), Floating Rate Bond ETF (FLOT), SPDR Bloomberg Barclays Short Term High-Yield Bond ETF (SJNK), PowerShares Senior Loan Portfolio (BKLN) and Vanguard Short-Term Corporate Bond ETF (VCSH) sank to a record low outflow of $18 million after the first week of 2018.

The ETFs all have one thing in common: short durations.

Duration, or the time to maturity for a debt security, is a measure of interest rate risk that can be used to divine the expected change in a bond’s price given a move in rates. Long-dated and low-risk bonds -- like U.S. Treasuries -- tend to have the highest duration risk.

All of these low-duration ETFs are trouncing their peers that carry a high degree of interest rate risk -- like Vanguard’s Long-Term Bond ETF (BLV) and the iShares 20+ Year Treasury Bond ETF (TLT) -- out of the gate in 2018.

Demand for Treasuries that are split into principal and interest-only securities, also known as Strips, hit a fresh record in 2017, underscoring the immense appetite for duration among liability-driven investors and pension funds.

Investors had flooded into low-duration products in the wake of President Donald Trump’s surprise victory in the U.S. election and the run-up to the Federal Reserve’s lone rate hike of 2016, a time when the yield curve was steepening swiftly amid hopes that pro-growth fiscal policies would soon be enacted.

“I think it’s just a natural slowing as duration fears ebbed in 2017 and the market is only priced for about two hikes in 2018,” said Stephen Caprio, a New York-based credit analyst for UBS Group AG. “That said, some marginal fears about duration are starting to grow.”

He cited a modest slowing of inflows to investment-grade bonds, which typically have more interest rate risk than their junk-rated counterparts.

Peter Tchir, head of macro strategy at Academy Securities Inc., highlighted several product-specific features of the aforementioned ETFs that might be contributing to a lack of investor interest, especially given the juicier yields on short-term U.S. debt.

“I think in case of BKLN in particular, investors are reluctant to bear the additional credit risk,” he said. “The problem is if you own floaters as rates start declining, they tend to be hard to sell...so better not to buy them close to peak hikes.”