In April, BlackRock launched a three-year, fixed-income ETF called iSharesBond 2016 Investment Grade Corporate Bond ETF(IBCB) with $10 million. Just four short weeks later, the ETF has attracted an additional $5 million in investments. IBCB is one of four in a series of fixed-maturity ETFs that have attracted an additional $20 million in investments overall.

“It confirms that more money is flowing into shorter-term, fixed-income ETFs,” said Matt Tucker, head of iShares fixed-income investment strategy at BlackRock, who was a speaker at a BlackRock’s press conference last week regarding ETF use among institutional investors.

About $11 billion went into short-term bond ETFs over the past year, according to Morningstar. That’s compared to $6.7 billion a year ago. Investors increasingly are concerned about duration risk, which indicates how much a bond will fluctuate in price when interest rates go up or down. The higher the duration, the greater the bond’s sensitivity to interest rate changes. And that can have a direct impact on the value of a fixed-income ETF.

“Many investors are concerned with duration risk in long-term treasuries and other fixed-income vehicles, said Andy O’Rourke, a managing director with Direxion. “The natural reaction is to take an even more conservative approach and seek shelter with short-term, fixed-income vehicles.”

He added this indicates that investors still aren’t ready to plunk a significant amount of their assets into the equity markets, so they’re taking an ultra-conservative stance in the fixed-income space out of fear that interest rates will increase.

“When interest rates rise the value of principal decreases,” said Noah Hamman, CEO of AdvisorShares Investments, which launched its two-year duration Newfleet Multi Sector Income ETF (MINC) two months ago with $5 million in assets. The fund now has $78 million in assets and is invested in corporates, international corporate debt, Treasuries and mortgage backed securities.

“The main appeal of short-term, fixed income ETFs are their lower duration and opportunity for lower loss of principal risk,” Hamman said.

According to BlackRock, the flows into its intermediate fixed-income iShares iBoxx $ Investment Grade Corporate Bond Fund (LQD) with an average eight-year duration has been negative $1.2 billion compared to positive flows of $1.2 billion into its three-year iShares Floating Rate Note Fund (FLOT).
“Like many other fixed-income investments, if people invest in a short-term duration ETF they will be better protected against rising interest rates but the trade-off is less yield in return,” Tucker said.

With duration of three months, BlackRock’s FLOT ETF has yielded 58 basis point compared to LQD’s 2.93 percent yield. “Investors are moving out of ETFs like LQD because even though they offer more yield there is concern about rising interest rates,” Tucker said. “These two ETFs are a good example of the relative yield trade-off investors are making and where the flows are year to date. In today’s market, people are more comfortable taking on credit risk and investing in corporate bonds and less comfortable taking on duration risk and investing in long-term duration investments.”

Six-month Treasury bills are yielding eight basis points compared to 1.89 percent for 10-year Treasuries. “Options appear to be limited within the traditional asset classes, which is exactly why we educate advisors and investors about using alternative asset classes and strategies, such as managed futures, commodities and currencies,” O’Rourke said. “If used properly, these strategies can help diversify portfolios and seek potential revenue streams away from traditional asset classes.”

While Direxion Funds eliminated its two-year fixed-income ETFs in November 2010, State Street, AdvisorShares, Vanguard and Pimco are consistent with their short-term, fixed-income ETFs. “There was very little traction in it,” O’Rourke said about Direxion’s Daily Two-Year Treasury Bull 3x Shares (TWOL) and Daily Two-Year Treasury Bear 3x Shares (TWOZ).

Watching The Fed

Vanguard’s Short-Term Bond ETF (BSV) is the largest ETF in its category, with $12 billion in assets invested across corporate and government bonds. It has raked in $4.6 billion over the past 12 months through the end of April, while the Pimco Enhanced Short Maturity Exchange-Traded Fund (MINT), an actively managed ETF with an average maturity of one year, had inflows of $1.2 billion.

“Pimco is doing well, but three-year, fixed-income ETFs are doing better than one-year maturity vehicles because as interest rates fall the one with the longer maturity performs better,” said Morningstar ETF analyst Timothy Strauts. “Because we don’t know what will happen with interest rates, the fixed-income ETF with the best return now is not necessarily the best going forward.”

Unlike other short-term, fixed-income ETFs, BlackRock’s IBCB fund is 100% invested in corporate bonds while most short-term, fixed-income ETFs tend to own government bonds, which are less risky. With steady inflows for the last couple of years, State Street’s SPDR  Nuveen Barclays Short Term Municipal Bond ETF (SHM) invests in short-term treasury and municipal bonds for tax-free income and an average maturity of three years. The fund has $2 billion in assets.

Meanwhile, the iShares Barclays 1-3 Year Credit Bond Fund (CSJ) has had $558 million in assets added in the past year compared to SPDR Barclays Capital Short Term Corp Bond ETF (SCPB) ETF’s $1 million in inflows during the same period.

“We've seen a strong affect in the first quarter but the amount of inflows is levelling off in the second quarter," Tucker said. "As long as the Fed is active with quantitative easing and interest rates are kept low, investors will be forced to face the predicament of where to find yield. Investors need to step back and think about the role of fixed income in their portfolio and determine the risk they are willing to take on in order to pick up yield in the market."