SGOV: Standing Atop The Yield Cliff (NYSEARCA:SGOV)

Introduction

The iShares 0-3 Month Treasury Bond ETF (NYSEARCA:SGOV) provides investors with only bonds maturing within that 3-month mark, providing both safety and the highest rates of any treasuries currently on the market. Typically, these two things don’t go together, but the time we’re living in isn’t very typical.

To understand what I mean by today isn’t very typical, we need to understand how the yield curve.

In a normal world, we should expect the treasury yield curve, the graph you get when you plot various dated treasuries and their yields, to look something like this:

The curve slopes upward, indicating that the market’s economic outlook is for growth. It shows the expectation of lower rates now and higher rates in the future, with the highest rates being at the farthest out maturity, 30 years, in this case.

However, our current yield curve looks like this:

For investors wanting to stay toward the top of the curve (read as ‘cliff’), the iShares 0-3 Month Treasury Bond ETF provides investors with only bonds maturing within that 3-month mark, staying at the top of the curve before it falls off at the 1yr mark. This presents investors an opportunity to lock in rates above the 5% mark without much, if any, risk to the principal.

Standing atop the yield cliff, looking down at investors wanting to lock in current rates for the long haul, it doesn’t feel worth it to join them. The Fed projects us holding rates above 5% for another year. Until then, should we take the risk of a hard landing?

The Fed is worried about overstepping and forcing the issue. If more rate hikes are to come, investors currently buying on the long end of the curve will be burned. On the short end, rates will rise, and the price will mostly remain unchanged.

Brief Overview

At a glance:

• Price: $100.45

• Dividend Yield: 5.31%

• Beta: 0.00

• Volatility (1Y): 0.24

• 30-Day Trading Volume: 317,398,293.8

• AUM: $16,803,389,646

Description as per iShares:

The iShares 0-3 Month Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities less than or equal to three months.

The fund buys individual treasury bills and holds them to maturity, rolling into new bills as they are issued. This passive rolling method ensures that the fund is always kept up to date with whatever the current short-term yield is. In terms of total return, you can see its performance over the past year.

What Safety Looks Like

When you look at the price chart, you may notice something interesting: a whipsaw pattern.

Whipsaw means that the price falls as dividends are paid out of the fund, and then it rises again the next month, only to fall the same way as the dividend is paid out.

This is working as intended and demonstrates the safety of the fund. If you want to see how investors have actually done, you need to look at total return. Something fascinating appears on the three-year chart. Can you spot the moment the Fed began raising rates?

The whipsaw gets more pronounced and investors suddenly start accruing real interest. This change has given SGOV a lot of attention recently as a very attractive alternative to savings accounts and money markets.

Chutes and Ladders

I recently wrote a piece on the long-term treasury thesis and why investors would buy the far end of the curve. It has been beaten down and has shown little life, especially after the abject failure of the 30-year auction. With rate changes proving to be erratic and the long-term bond ETFs showing more volatility than the S&P during these failed auctions and economic data releases, I’m reminded of playing Chutes and Ladders as a kid.

For the uninitiated: the game is about spinning for a random number and climbing ladders, hoping you won’t be sent back down by a chute. Whoever gets to the top, square 100, wins.

In the long run, the best strategy in the game is being lucky. When an investor buys a long-term bond, they get to spin. They may land atop the yield curve or at the bottom of the yield cliff, depending on how the Fed acts. Investors cannot predict how the Fed will react, as we’ve seen in the last few years with Fed decisions moving markets erratically.

Is the best strategy not playing at all? An extremely low duration play like 0-3 month T-bills is about as close to “not playing” the game. The Fed’s projections don’t affect the low-duration bills, so we never have to spin. Due to the ultra-low duration of these bonds, virtually zero, interest rate changes have little to no effect on the prices of these bonds.

Take a look at the price returns on short-term vs. long-term bonds over the past year.

Normally, not playing also means you don’t have any fun, as we can see from SGOV’s stagnant price. However, we see something interesting in the rates of these instruments. Abnormally, because of the inverted yield curve, these short-term bonds are paying more. Less risk of loss and a higher dividend means there is little reason to want to buy long-term bonds right now.

For the most part, the short-term bills (using BIL here instead of SGOV since it has a longer history and can go back the full ten years) almost always have rates lower (and thus a lower total return) than the long-term. That is, up until the yield curve inverted.

Above is the normalized change in total return between the two in the last decade, which is notable for being a period of extremely low rates. As commentators predict a “new, new normal,” we should expect long-term treasuries to potentially level off and settle until rates change again.

In hindsight, it’s hard to tell if it was better to take a spin or sit the game out. When Team Transitory announced that inflation would just go away on its own regardless of near-zero rates, I should’ve stopped playing the game.

Compared to Money Markets

With a 5% yield looking to hold up for some time, investors are asking: how does this stack up to my core cash holding?

If you’re familiar with how these two instruments are constructed, skip down to the first graph.

For a comparison, I chose the Vanguard Federal Money Market Fund Inv (VMFXX) since it is the largest money market fund in the US.

Metric	SGOV	VMFXX
Price	$100.45	$1.00
Expense Ratio	0.07%	0.11%
Yield	5.31%	5.28%
Distribution	Monthly	Monthly

Click to enlarge

1. Nature of the Instrument:

   • SGOV: An ETF that primarily invests in short-term U.S. Treasury bills. Its price can fluctuate throughout the trading day.
   • VMFXX: A money market mutual fund that invests in high-quality, short-term instruments like U.S. government securities, repurchase agreements, and cash equivalents. It aims to maintain a stable net asset value of $1 per share.

2. Liquidity and Trading:

   • SGOV: Can be bought and sold throughout the trading day at market prices, which may differ from its NAV.
   • VMFXX: Transactions are based on the fund’s NAV, which is calculated at the end of the trading day. Redemptions are typically settled on the next business day.

3. Safety and Credit Risk:

   • SGOV: Primarily invests in U.S. Treasury bills, which are backed by the full faith and credit of the U.S. government, making them low-risk.
   • VMFXX: While it invests in high-quality instruments, it may also include repurchase agreements and other securities, diversifying its holdings but potentially introducing minimal credit risk.

Counterpoints

This is a very safe trade, and a replacement for high-yield savings and other short-term money investors want to put to work.

The most glaring counterpoint is opportunity cost. What if rates do actually go down and the long-term trade gives a better payoff? You can’t win Chutes and Ladders if you never spin.

This opportunity cost of waiting for rates to climb again can kill an investor’s total return, as shown by the last decade. There was a tremendous opportunity cost for sitting in the short term.

“Safe” here is relative, too. These are only as safe as the US government’s ability to pay off its debt. I’m in no way trying to insinuate that the government may actually default, but it doesn’t have to for its bonds to become more speculative.

Recently, the government was given a credit downgrade. This isn’t a huge deal and was mostly symbolic, but there are other Western nations where bonds are not taken nearly as seriously (looking at you, Greece, et al.) and investors are more likely to speculate on. If this issue got worse, or the game of chicken with the debt ceiling went wrong, short-term bonds could have more fluctuations and not hold value as well. You may end up playing Chutes and Ladders whether you like it or not.

Conclusion

It’s prudent for investors to consider the current macroeconomic environment as an opportunity to capture a high yield for little risk. It makes little sense to “play the game” and extend the duration currently.

To that end, SGOV offers investors a way to exploit the high end of the yield curve. In the future, extending the duration might be the smart move. Until then, short-term offers a much more compelling risk-to-reward ratio for investors.

Until the curve flattens back out, I’m keeping the bulk of my liquid cash in the short term. For those of us who shirk away from risk, it’s easier to think about hiking up a curve than jumping off a cliff.