ICSH ETF: Ultra Short-Term, Ultra Low Volatility, But Carries Some Risk

By Rob Isbitts

Strategy

The iShares Ultra Short-Term Bond ETF (BATS:ICSH) is a short-term bond ETF. Its portfolio allocates to bonds denominated in US Dollars, and which are rated BBB- or higher by rating services S&P Global or Fitch, or Baa3 or higher by Moody’s. The ETF will invest in bonds which are not rated, if ICSH’s managers believe those bonds are of similar quality to those which meet its minimum rating. ICSH invests nearly all of its assets in bonds maturing during the next 3 years.

Proprietary ETF Grades

• Offense/Defense:Defense

• Segment:Cash Alternatives

• Sub-Segment:US Mixed Sector

• Risk (vs. S&P 500):Very Low

Proprietary Technical Ratings

• Short-Term (next 3 months): Hold

• Long-Term (next 12 months): Buy

Holding Analysis

ICSH’s current holdings are concentrated around the 1 to 3 year maturity range. 64% of the ETF is invested there. Nearly 1/3 of the fund matures in under 1 year. From a ratings standpoint, AA and BBB bonds each make up just over 1/4 of assets, with most of the remainder in bonds rated A. There is a small (under 3%) position in bonds with AAA ratings. This ETF is very widely diversified, with 465 holdings as of this report.

Strengths

ICSH is one of those ETFs we’d really like a lot if we weren’t so concerned about a credit “event” during 2023. We are being “sticklers” in that ETFs focused on US Treasuries are our favorites for now. But as credit bond ETFs go, this one has a lot going for it, now that yields have popped higher. Its holdings tend to average about an A rating, which means it picks up some yield without going “all in” on junk-rated bonds (BB and lower). In fact, this ETF doesn’t go into junk at all. Its entire portfolio is rated BBB or higher. And, with maturities under 3 years in most cases, and a puny Effective Duration of under 0.5, there’s a lot to like here. This is a $7 Billion ETF. That sounds gigantic, but is actually a Goldilocks size for this part of the ETF world. It is not too small, and not too large and inflexible.

Weaknesses

Ah, but the BBB rating zone is still potentially a danger zone. As we see it, this could be the biggest bond market issue of 2023. BBB bonds are now a very large portion of the “investment grade” bond market. That’s no accident. Many bonds snuck in under the proverbial wire with BBB ratings, in what we believe was a market-wide trend toward “grade inflation.” In reality, many BBB-rated corporations and entities are at great risk of being downgraded. The number of “zombie corporations” which can only stay alive if they can continue to borrow, are at risk of having to incur much higher interest rate costs on their short-term debt. While this is a much bigger issue for longer-term bonds, we remember all too well how short-term bond funds were wrecked during the Global Financial Crisis of 2008. Will history repeat itself? We have no idea, but we are accounting for that possibility, among several others.

Opportunities

The real opportunity in ICSH could come after a credit market disruption. Yields are up across this segment of the bond market, and ICSH now yields over 4.7%. That’s the highest level in the ETF’s 9-year history. This is what a record-quick Fed rate hike cycle can do for a fund like this one.

Furthermore, ICSH, issued by ETF behemoth iShares, is not an index fund. It is actively managed, which means that the managers may be capable of steering the fund around market icebergs, if that skill is required in the near future. As with other short-term bond ETFs we’ve covered recently, investors should note that the “Yield” quoted in basic financial data services is based not on what the fund would pay for new owners, but rather an average of dividend payments from the ETF over the past 12 months. For much of that period, yields were near zero. Now, they are up more than 1,000% from those levels. That makes the 12-month yield figure totally inaccurate for a current holder or investor.

Threats

Rates are waffling now, but have settled nicely in the 4%+ range for ETFs like ICSH. But upward pressure on rates could continue. And, while this fund has never lost more than 4% from peak to trough, we do live in unprecedented times. So, the biggest threat to us is continued runaway rates, a credit crunch or both.

Conclusions

ETF Quality Opinion

We like ICSH from a structural standpoint. And there will come a time, maybe soon, where getting that extra yield boost from dropping down from US Treasuries to AA, A and BBB-rated bonds will be worth it.

ETF Investment Opinion

But for the moment, we don’t think it is worth it. Essentially, our personal “risk premium” to shift significant capital from short-term US Treasury ETFs to ICSH is more than the couple of dozen basis points we would receive now. Show us another ratcheting up of short-term rates, and a clearer coast when it comes to credit market conditions, and it may be a very different story. For now, ICSH is a solid Hold, but not a Buy.