The iShares Barclays Capital US Treasury Bond 1-3 ETF offers investors exposure to the performance of the short-dated maturity segment of the US government bond market. Non-US-based investors have to take into account that this is a USD-denominated financial product. As such, it is likely to work best either as part of an investment portfolio with a US geographical bias or as a hedge to non-US fixed income holdings. In either case, but particularly so if the ETF is to be used tactically, foreign exchange considerations would have to be factored in investment calculations.
The ETF’s short-dated maturity bias, the choice of highly liquid instruments and the perceived near-zero chance of a US sovereign default, make this ETF a low-risk candidate to equitise USD cash holdings in core portfolios of non-US-based investors. Current fundamentals remain characterised by ultralow yields. However, the underlying demand for safety of the past years has allowed this fund to post nominal returns above key US money market rates.
The US economic recovery is proceeding at a moderate pace. Domestic private consumption, though showing some signs of improvement, remains hamstrung by what still are challenging labour market conditions and uncertainty over fiscal policy. The US government technically avoided the feared “fiscal cliff” at the turn of the year with a last minute compromise on tax increases and spending cuts, but further negotiations to lift the country’s debt ceiling are still pending. Besides, the already approved deal implies a tightening of fiscal policy in 2013 which could negatively impact growth. As such, the US economy is still unable to generate enough new jobs to allow for a substantial decrease in the jobless rate, which remains close to 8.0% as we write. Overall, the balance of risks to the US economic outlook remain skewed to the downside, with the situation in the Eurozone still cited as a key concern despite the marked easing of financial market tensions in H2-12.
Against this backdrop, the US Federal Reserve (Fed) remains committed to a very accommodative monetary policy stance. Fed Funds have been held in a 0.00-0.25% target range since December 2008, and they should remain unchanged as long as unemployment remains above 6.5% and inflation between one and two years ahead does not deviate by more than 0.50% from the Fed’s long-term price stability target of 2.0%. Given the relative weakness of private consumption and the absence of wage-led pressures, inflationary pressures are being kept broadly at bay, while inflation expectations remain subdued. As such, the current policy settings could remain unaltered for the foreseeable future.
Additional policy stimulus, particularly targeted at unclogging financial lending channels, push long-term interest rates down, and ultimately avoid a deflationary trap, has come via a large-scale programme of asset purchases, known as quantitative easing or QE. It is estimated that the Fed holds well over USD 2Trn of US Treasuries, agency debt and mortgage backed securities (MBS). The latest phase of QE, which started in September 2012, will continue throughout 2013 on an enhanced basis, with the Fed buying USD 40bn of MBS and USD 45bn of long-dated US Treasuries every month. The Fed will also maintain its policy of reinvesting all principal payments from its holdings into MBS and US Treasuries at auction. All this is designed to exert downward pressure on long-term interest rates and facilitate cheap financing to economic agents.
Global investors may take some comfort from the fact that the US Federal Reserve remains willing to act as “borrower of first resort” in the US Treasury market. However, any sustained improvement in overall market sentiment should favour reallocation of money flows into riskier assets, thereby putting upward pressure in US Treasury yields.
The Barclays US Treasury 1-3y Term Index is produced by Barclays Capital. The objective of the index is to measure the performance of short-dated fixed-rate government bonds issued by the US government. Term indices are a Barclays Capital in-house indexing methodology which uses standard market capitalisation weighting on a bond universe made up of issues near their original term rather than selecting all bonds in the maturity bracket.
The index is calculated on a daily basis using mid-market prices from the Barclays Capital market makers at 15:00 New York time. The index is reviewed and rebalanced once a month on the last calendar day of the month. At rebalancing, bonds eligible for inclusion in the index must have an original term of between 1.25 and 3.25 years, a minimum calculated life of 1.25 years and a minimum outstanding of USD 5bn. The index must contain a minimum of six bonds at rebalancing. Income from coupon payments is reinvested monthly at rebalancing. Income received during the month is invested until rebalancing at 1M USD Libor -15bps set at the end of the month for the next month.
iShares uses physical replication to track the performance of the Barclays Capital US Treasury 1-3 Term Index. This ETF was launched in June 2006 and is domiciled in Ireland. This is a USD-denominated investment vehicle. This ETF distributes dividends on a semi-annual basis, with historical data showing a March-September payment pattern.
The restricted bond universe that Barclays Capital uses to construct its term indices tipically allows iShares to fully replicate the basket of constituents. However, the statistical weighting of individual components may differ slightly between fund and index and this may have an impact on the fund’s tracking performance at the margins. Historical performance data shows that tracking difference has been kept in a fairly tight range over the lifetime of this ETF. A snapshot at the time of this writing (e.g. end January 2013) showed that the ETF basket was made up of 26 US short-dated government bonds, with weightings ranging from 1.5% to 7.0%.
iShares may engage in securities lending in order to optimise the ETF’s tracking performance. BlackRock acts as investment manager on behalf of iShares. The amount of securities that can be lent is capped at 50% per fund. Lending operations are hedged by taking UCITS-approved collateral greater than the loan value and by revaluing loans and collateral on a daily basis. The collateral is held in a ringfenced account by a third party custodian. The degree of overcollateralisation is a function of the assets provided as collateral, but typically ranges from 102.5% to 112%. Lending revenue is split 60/40 between the ETF and BlackRock, respectively.
The annual total expense ratio (TER) for this ETF is 0.20%. Additional costs potentially borne by investors and not included in the TER include bid/offer spreads and brokerage fees when buy/sell orders are placed for ETF shares.
iShares was quick off the mark with regards to providing European investors with European-domiciled ETFs tracking the US Treasury market, managing to capture the bulk of market share in the process. As we write, iShares remains the dominant force in this particular market segment.
From 2009 onwards other European ETF providers have come to the marketplace in a bid to challenge iShares’ supremacy. First off was Credit Suisse (CS) with the iBoxx USD Government 1-3 ETF (TER 0.23%), followed by db x-trackers with the iBoxx USD Treasury 1-3 ETF (TER 0.15%), Amundi with the US Treasury 1-3 ETF (TER 0.14%), Lyxor with the iBoxx USD Treasuries 1-3y (TER 0.17%) and UBS with the BarCap US 1-3y Treasury Bond ETF (TER 0.22%).
As of this writing, all these products lag iShares by a very substantial margin in AUM terms. It is worth noting that CS and UBS use physical replication, while ETFs from db x-trackers, Amundi and Lyxor are synthetic (e.g. swap-based). It is also worth adding that the CS ETF could be merged with the iShares ETF if/when the acquisition of Credit Suisse ETF business by Blackrock is completed.