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With the US interest rate increasing so much lately, I am interested in putting some more of my money into US treasury bonds. I am looking at the SHY ETF on Fidelity, which is an ETF comprising short-term (1-3 year) treasury bonds.

Now, I am far from an expert in bond investing and perhaps I am misinterpreting, but looking at the numbers that are shown, the annual yield looks pretty poor. The most recent distribution on 11/1 was $0.14, which is monthly. So, annualized that would be $1.68. The current market price for SHY is about $81, which seems like it will give an annual return of around 2.1%.

As far as I am aware, the current interest rate on short-term US treasury notes is somewhere around 4.5%. So, why does the apparent yield from SHY seem so low, by comparison?

I understand that an ETF is going to contain bonds that were issued over the past 2-3 years, which would have been issued at much lower interest rates. However, if bond interest rates rise, shouldn't the ETF market price drop to give a similar % yield (otherwise, why would anyone consider buying this ETF)?

Am I missing something?

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    Did you ever get an answer on this? Your question makes tons of sense to me, and none of the answers seem to actually explain why the 30-day SEC yield is still so much higher than the actual distribution?
    – Justin
    Apr 21, 2023 at 0:40
  • @Justin you make a very good point and I must admit I am still a bit confused about it. The answers that were given seemed to focus on explaining the terminology and definitions, but I don't think any of them really addressed the apparent discrepancy between the 'technical numbers' and the actual distributions being made.
    – Time4Tea
    Apr 21, 2023 at 11:11
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    I also asked Blackrock directly. We'll see if they respond. The "30 day SEC yield" is highly misleading, but I believe I know what's happening. I believe that if you hold this fund past its average maturity, you will be guaranteed to get a 4% annual yield; I believe this just shifts the payouts, and will include a potential capital gains portion (i.e., the price of SHY will rise if yields fall, to get us to 4%). But I am hoping Blackrock will confirm. The math and mechanics of this fund are confusing and it's surprising they don't share more information with investors.
    – Justin
    Apr 21, 2023 at 15:17
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    Also, for any potential answerers, what we're confused about here isn't bond math, it's bond fund math and how a buyer of this instrument will see yields going forward.
    – Justin
    Apr 21, 2023 at 15:20
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    am i crazy or do we still not have any answer on why this fund is paying out 2.6% but advertising a 4% 30-day SEC yield? I don't think Blackrock is just making up numbers, so it seems like there has to be something that we aren't understanding.
    – Justin
    Apr 24, 2023 at 14:52

3 Answers 3

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+50

Both answer given so far by @0xFEE1DEAD and @Kevin Arlin are correct. I'll just add some concrete numbers. The average coupon (weighted by market value of the bonds) of SHY ETF is currently ~2.36%. The computation with code will be given below. Yield is something very different and looks at the current price (not what you bought it for). That is no different to bonds really. What is different is that the ETF will never hold the bonds to maturity.

SEC Yield

The SEC yield is not directly a measure of the returns to be expected from a fund, but rather serves as a consistent benchmark for yield performance comparison. It does not account for the fact that most funds do not mature, nor does it consider that most bonds are not held until maturity. In a nutshell, the SEC yield is basically a YTM adjusted for fees (approximate computations will be shown below).

VANGUARD states that

SEC yield requires averaging the yield to maturity of the fund’s holdings over the prior 30 days and accounts for fund expenses.

SHY ETF

Per prospectus, SHY ETF seeks to track the ICE® U.S. Treasury 1-3 Year Bond Index (the “Underlying Index”), which measures the performance of public obligations of the U.S. Treasury that have a remaining maturity of greater than or equal to one year and less than three.

  • All eligible securities must have a minimum term to maturity of at least one year
  • The composition of the Index is rebalanced at each month-end.
  • The Index is not adjusted for securities that become eligible or ineligible for maintenance inclusion during the month. Any such changes are incorporated in the following month’s index. That explains why there are frequently some bonds with less than 1 year in the index. Nonetheless, they are never held to maturity.

The rest is basic bond math. Yield to maturity (YTM) is a measure that considers the NPV of the bonds. However, if you bought the bond prior to the YTM calculation, or do not hold until maturity, you cannot expect to obtain the YTM. The prospectus also explicitely warns of the risk that

An increase in interest rates will generally cause the value of securities held by the Fund to decline.

Is there a potential for arbitrage?

Contrary to @Justin suggestion, there is no possibility for arbitrage. The ETF is holding actual bonds. It would be the exact same if you buy the bonds yourself. The bonds pay a fixed interest, irrespective of where the bond trades. The yield of the bonds is a hypothetical result, that states that you would get this return if you bought the bond now and held it to maturity. The problem is that you (almost never) buy a bond now and in the case of the ETF never hold to maturity.

Simplified example:

You buy a bond at face value USD 100 that pays 4.75% interest and hold to maturity you will get USD 4.75 interest every year and your USD 100 back at the end. However, assume the current price of the bond is USD 144.57. We know this can only be the place if the interest rate in the market is significantly below the coupon of the bond. This bond now yields only 0.47%. If you buy it now, and hold to maturity, that will be your return. You still get 4.75% interest, but the problem is that you also still only get USD 100 back at maturity.

This is a real example, with actual market data. The details and Julia code can be found here.

The ETF has the opposite effect right now. Bond prices went below par because market interest rates keep rising. However, the currently held bonds pay, on average, just about 2.36% coupon. When the ETF needs to sell these bonds because they are no longer eligible (< 1 year for example), the ETF immediately faces the loss associated with the decline in the market value of the bond. You also cannot get rid of the bonds and buy higher yielding ones, because the loss in market value is already in your positions. The outcome is the same had you bougth the bonds yourself, and you would face the same return. If you were to buy the bonds now, you would have a higher total return, including the price appreciation. However, the coupon will still be the average coupon of the bonds held. Also, if you think you just hold to maturity, you cannot compare your return to that of the ETF because you look at two very different strategies. Hence, there is no arbitrage.

So why would anyone buy SHY if you could buy securities directly that reflect higher yields?

  • If you buy bonds, you will face the same interest income (see the previous paragraph)
  • You need to make only one trade to get a fixed-income portfolio
  • The pay-out is monthly because the ETF holds many bonds at once (related to the last point above)
  • The ETFs maturity is more or less constant making it a great vehicle for duration hedging
  • Bond ETFs are liquid (not so much a benefit with US treasury but very much so with less liquid bond markets)

Why not?

  • (Bond) ETFs never mature. Therefore, rising rates can result in selling bonds at low prices which can lead to losing money. You will face the same downside if you do not hold bonds to maturity. In fact, SVB bank went bancrupt because of the decline in the bonds market value.

Some interest rate facts

Now, let’s look at the FED Funds rate as a Benchmark relative to the 3-year CMS Treasury rate vs SHY ETFs NAV. There are two historical extremes in the current time span of eligible maturities. First, rates were at historical lows due to COVID-19 and recently, rates were hiked at almost unprecedented speed.

enter image description here

It is not a coincidence that bond funds and ETFs perform very poorly if rates hike as they did in the last couple of months. The following graph shows Fed Funds, 3 year and 1 year Treasury rates. Any bond issued just a few weeks or months ago is already below par with such pronounced rate hikes. This implies yield will go up in line with current market rates. However, the coupon will still be lower, and the price of the bond went down, which means you will lose money when you sell it.

enter image description here

For example, below is a list of returns from Morningstar.

enter image description here

It is also natural that long term bond ETFs suffer more than short term bonds. The reason is basic discounting (time value of money). Exact YTM and NPV calculations with Julia code can be found in this answer. It is sufficient to keep in mind that as long as interest rates keep increasing at the current pace, and the ETF is holding "old" bonds, the return will be a lot lower compared to yield, because the NPV of the bonds decreases substantially.

Some numbers

The Julia dataframe below is showing the current biggest holdings, which you can retrieve directly from BlackRock. You can see the biggest position has only a coupon of 1.5% and most are priced significantly below par. This is because they were issued at a time where interest rates were still lower.

enter image description here

Computing the average coupon of all currently held bonds, weighted by market value looks like this:

avg_coupon = sum(shy_holdings[!,"Coupon (%)"].*shy_holdings[!,"Market Value"])/sum(shy_holdings[!,"Market Value"])
println("Market value weighted average YTM of SPY ETF =  $(round(avg_coupon, digits=3))")
Market value weighted average YTM of SPY ETF =  2.367

As for the math and details, it really is all there and also very similar for every bond fund /ETF /investment. Fixed income is just more complicated than the name suggests (after all, anything fixed sounds like it’s easy to understand).

SEC Yield continued

SEC Yield for bonds funds is NOT related to the dividend of the bond fund. It is a standardized YTM computation. Most online resources do not really show detailed computations but merely show more or less the same text. You can find a detailed explanation in this FORM OF AMENDED AND RESTATED YIELD CALCULATION SERVICES AGREEMENT from the SEC.

enter image description here

To get to the exact number is cumbersome, but if you simply take the displayed YTM and adjust for 360 vs 365 daycount (US Treasury Convention) and subtract the fee, you get reasonably close. You can also use compute the market value weighted YTM directly with the dataframe above.

avg_ytm = sum(shy_holdings[!,"YTM (%)"].*shy_holdings[!,"Market Value"])/sum(shy_holdings[!,"Market Value"])
println("Market value weighted average YTM of SPY ETF =  $(round(avg_ytm, digits=3))")
Market value weighted average YTM of SPY ETF =  4.258

If you now divide by 365, multiply be 360 and subtract the expense fee of 0.15, you get

println("Approximate SEC 30D yield =  $(round(avg_ytm/365*360-0.15, digits=5))")
Approximate SEC 30D yield =  4.04967

which isn't too bad an estimate.

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  • What is the math to get to the 4.03% 30-day SEC yield they advertise? If there is an 18c dividend in the past 30 days, I'm getting a 2.7% annualized yield. I'm confused about the differential between these numbers.
    – Justin
    Apr 24, 2023 at 14:20
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    @Justin again, it doesn't work that way. You're basing your calculation on the dividends distributed by the fund, rather than the dividends/interest earned by the fund...
    – 0xFEE1DEAD
    Apr 26, 2023 at 3:05
  • got it, so you're saying they're earning interest that isn't being paid out yet (because the underlying securities don't always pay out monthly)? if this is the case, should we expect larger lump sum distributions in the future when that happens?
    – Justin
    Apr 26, 2023 at 15:51
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    @Time4Tea it seems like we have some good work and answers here if you want to choose one so they get the bounty. Big thanks for all the help 0xFEE1DEAD and AKdemy and MorrisonChang (this won't let me hyperlink more than one)
    – Justin
    Apr 26, 2023 at 18:26
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I'm pretty sure it's as simple as that it takes some time for holdings to turn over. The Fed only first hiked rates in March, and the March and May hikes were not the big 75 bp hikes we've seen since. Thus SHY was holding bonds with a coupon of about 0% until just a few months ago. SHY's purpose is to hold bonds with a remaining maturity of 1-3 years, which as I understand it means they more or less never hold bonds till maturity; that means SHY's yield comes from actual coupon payments together with time decay of holdings that were purchased below par. Treasuries only pay out every six months, so SHY hasn't received coupon payments from any of its current holdings with a high coupon. Similarly, for time decay, SHY's trades were probably almost all at a loss all year as rates steadily shot upward; it's only now that it can begin to hope that it can realize effective yields of 4% or so on recent purchases, which will steadily become more obvious over the next six months or so in its distributions.

Indeed, while the most recent distribution annualizes to only about 2%, if you look further back, you can see it's quintupled since this spring. Sure, it hasn't yet caught up to the yield of a treasury you could buy directly, but if you did that, you'd still have to wait for either a coupon payment or for some time decay! So there's no easy way to do very much better than with SHY.

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    "it means they more or less never hold bonds till maturity" ---> not necessarily. It means they don't have to buy on-the-run securities that were issued with a 1-3Y maturity. For example, they could buy 5Y or 10Y bonds that were issued several years ago with only a few years remaining until maturity. You can refer to the iShares website for a list of the actual holdings. Also, I'm not sure what you mean by "time decay"?
    – 0xFEE1DEAD
    Nov 29, 2022 at 3:26
  • Ok, thanks. So, you would expect the monthly distribution amounts to increase quite rapidly in the next 2-3 months?
    – Time4Tea
    Nov 29, 2022 at 11:38
  • @0xFEE1DEAD By "time decay" I mean the appreciation of the trading price of a bond with coupon below its current yield, as it converges to the face value upon maturity. I don't know whether there's a normal way to refer to this, just seemed analogous to an option. I'm not sure I see your point about 5Y or 10Y bonds with 1-3 years maturity; if you look at SHY's holdings, you'll see there is indeed no holding with a remaining maturity of more than 11 months. And holding bonds with remaining lifetime 1-3 years is indeed what they claim to do. Nov 29, 2022 at 20:24
  • @Time4Tea Yes, I expect that process (which is already very visible) to continue. Nov 29, 2022 at 20:25
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    @KevinArlin ok I see what you mean. Generally speaking you're right that they usually won't HTM but there's some flexibility (currently about 9% are allocated to the 0-1Y bucket)
    – 0xFEE1DEAD
    Nov 29, 2022 at 21:51
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As of 11/23, the "30 Day SEC Yield" is 4.45%, whereas the backward looking"12m Trailing Yield" (TTM) is only 0.92%

https://www.ishares.com/us/products/239452/SHY

-- Edit --

Hopefully this will clear up some of the confusion around SEC yield vs distribution yield:

The standardized formula for the 30-day SEC yield consists of four variables:

a = interest and dividends received over the last 30-day period

b = accrued expenses over the last 30-day period, excluding reimbursements

c = the average number of shares outstanding, on a daily basis, which were entitled to receive distributions

d = the maximum price per share on the day of the calculation, the last day of the period

The formula of the annualized 30-day SEC yield is:

2 x (((a - b) / (c x d) + 1) ^ 6 - 1)

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  • Thanks for your answer. However, I still can't quite square this with the most recent monthly distribution on 11/1 being only $0.14. Is the '30 day SEC yield' expecting that the monthly distribution will be increasing in the future?
    – Time4Tea
    Nov 29, 2022 at 11:36
  • Several months later, the 30 day SEC yield is still far above actual distributions.
    – Justin
    Apr 21, 2023 at 0:43
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    @Justin I believe you are mistaken as to the purpose of those values in the 'Portfolio Characteristics' section. Be aware that 30-Day SEC Yield is forward looking for 12-months. What does the "SEC 30-Day Yield" mean for a Bond ETF? and should be used as a comparison between similar instruments. Apr 21, 2023 at 19:08
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    @Justin you're probably not considering that bonds typically pay coupons semi-annually when you annualize the yield. Also, the SEC yield is computed based on the market cap, not simply the price.
    – 0xFEE1DEAD
    Apr 25, 2023 at 0:40

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