SPSB: The Sweet Spot In Short-Term Corporate Bonds Yielding +5.5%

The SPDR Portfolio Short Term Corporate Bond ETF (NYSEARCA:SPSB) invests across U.S. investment-grade corporate bonds with a maturity between 1 and 3 years. In this case, SPSB isn’t necessarily the most conservative bond fund in the market, but it can be a good alternative to cash or money-market funds.

When thinking about bond funds, there’s always going to be a trade-off between return potential, risk, and yield. The attraction here is the opportunity to earn a modestly higher return compared to corresponding Treasuries with a relatively low-risk profile.

We believe SPSB hits a sweet spot in the current environment balancing what remains some macro uncertainty and volatility at the long end of the curve while offering a compelling +5% yield through a monthly distribution.

What is the SPSB ETF?

SPSB is intended to track the “Bloomberg U.S. 1-3 Year Corporate Bond Index” covering the universe of investment grade, fixed-rate, U.S. dollar-denominated debt with at least $300 million of par value outstanding.

With an expense ratio of just 0.04%, the fund is a low-cost option for investors to access this otherwise no-frills segment of corporate bonds. The idea with short-term fixed income is that the value of the issuances has limited sensitivity to interest rate risk. The concept known as duration for SPSB is measured at around 1.8 years corresponding to the average maturity of the underlying holdings.

One way to think about that number is that since the average bond is maturing in less than two years, changes to interest rates have a limited amount of time to impact the associated cash flow net present value. Bonds with a longer maturity and higher duration are going to be more volatile, all else equal.

In terms of the underlying holdings, SPSB includes more than 1,300 bonds from major corporations like Apple Inc. (AAPL), AbbVie Inc. (ABBV), and Visa Inc. (V) with maturities within 3 years.

These companies are recognized as investment grade by credit rating agencies based on their overall financial stability. The bulk of the portfolio has a credit rating in the A+ to BBB- category on A1 through BAA3 on the Moody’s scale implying a strong to adequate capacity for repayment.

Outside of a major financial crisis, the default risk is extremely low for any given company, with the fund itself featuring enough diversification that an unlikely credit event from a single name would not materially impact the value of the overall fund.

Safety During A Yield Curve Steepening

A major market theme this year is an expectation for the Fed to begin cutting interest rates this year. Whether that happens in March or May is up for debate, but the consensus is that inflation has cooled to a level that maintaining the Fed Funds rates at 5.5% is simply unnecessary.

Naturally, that outlook is a great backdrop for bonds, but the bigger uncertainty is how the yield curve and credit risk will evolve going forward.

Simply put, it’s possible the Fed cuts rates, pulling the short end of the yield curve lower, while the long end stays relatively flat, or even rises from here. This scenario, sometimes referred to as a “bullish steepening”, where the short-end of the yield curve falls faster than the long-end could be on the table for 2024.

We bring that up because such a setup would allow SPSB to shine given its short-term maturity and high-quality credit profile.

What we have right now is a relatively flat yield curve where the 2-year, 10-year, and 30-year Treasuries all yield around 4.2%-4.4%. It’s possible that as the Fed cuts and the spread widens where the 2-year yield begins to move lower while the 10 and 30-year remains above 4%.

The caution here is that if such a dynamic develops, running out and loading up on long-duration bond funds such as the SPDR Portfolio Long Term Treasury ETF (SPTL) or iShares 20+ Year Treasury Bond ETF (TLT), both with an effective duration above 16-years, would not deliver significant appreciation.

The reason that’s possible goes back to the economic environment being defined by stronger-than-expected activity and consumer spending levels. The result works to keep the risk that inflation returns down the line whether in 2025 or over the next decade. Without a “hard landing” type of recession, a bet that long-term bond yields will come crashing lower just because the Fed starts cutting short-term rates is far from certain.

What’s Next For SPSB?

If we had complete certainty that a particular stock or even a certain segment of the bond market would outperform from here, SPSB would not be necessary.

That’s where diversification and the ability to manage risk with short-term bonds come into play. If you already have a portfolio of risky stocks or bond exposure at the long end of the curve, adding SPSB would help balance the volatility while also offering a compelling yield.

We can annualize the last monthly distribution of $0.1267 per share to a forward yield of 5.1%. That said, the understanding is that given the trend of rising rates last year, bonds added to the portfolio into the second half of 2023 are now contributing to a higher yield to maturity as the older positions at a lower yield from pre-2022 fall out.

This means that there is room for the monthly distribution rate to climb higher through 2024 resulting in shareholders effectively capturing a larger dividend yield, likely above 5.5% by our estimate. That would be incremental to any appreciation of the underlying holdings as the 2-year yields fall alongside Fed rate cuts.

Overall, investors are looking at a fund with a good chance to deliver a total return of over 6% over the next year with little risk.

The other consideration here is the credit spread dynamics. In this case, it’s not necessarily a risk that the companies will default, but simply that the spreads widen from what are historically low levels. From the chart below, we use the “US Corporate A Option-Adjusted-Spread” as a proxy for credit risk currently at 0.81%.

This figure can be interpreted as A-rated investment-grade bonds, such as those in the SPSB portfolio command an incremental 0.81% yield over Treasuries to compensate for the higher risk. We can already see that as the 2-year Treasuries only yield 4.4% This is markedly lower compared to “high-yield” or junk bonds at the BB level with a 2.0% option-adjusted spread.

The reason we like investment grade here is simply in case the entire narrative is wrong, and the economy does indeed begin to roll over, it stands to reason that junk bonds have more to lose as high-yield credit spreads would face a wider repricing higher.

In other words, we believe high-yield credit spreads are underpricing risks on that side of the market which is another reason to favor investment grade and adds to the attraction of SPSB on a relative basis.

Final Thoughts

There are hundreds of bond funds with different exposures and it’s impossible to claim one is the best or that a particular strategy will outperform. What we can say for certain is that the SPDR Portfolio Short Term Corporate Bond ETF does a good job in this important category.

Ultimately, a scenario where interest rates decline modestly at the short end of the curve while economic conditions remain resilient should be positive for SPSB in 2024. On the other hand, the possibility that interest rates take a surprise turn higher would be a bearish development for the entire bond market, but SPSB would still be positioned defensively compared to a higher-risk corner of the market.