I almost never issue a “strong buy” rating on a stock or ETF. There is so much uncertainty about the future price behavior of any risky asset that I try to avoid “beating the table” on too many of my investment ideas.

However, for the reasons I present below, I believe that the Schwab Short-Term US Treasury ETF (NYSEARCA:SCHO) deserves to be a rare exception. In my opinion, this short-to-mid term treasury fund has one of the most compelling risk-reward profiles of any instrument I monitor.

What is SCHO?

Before delving into the investment thesis, it is worth taking a quick look at the Short Term US Treasury Schwab ETF.

It is a very low cost (4 basis point annual fee) $8 billion portfolio of over 90 fixed income instruments with maturities currently ranging from one to nearly nine years. The ETF has an effective duration of 2 years and the SEC yield is currently 2.3%. Monthly distributions to shareholders have totaled just 19 cents per share over the past 12 months, reflecting a very low yield environment in 2020 and 2021.

CHS trades on average of around 2 million shares per day, according to Yahoo Finance, making it a liquid ETF. The fund is currently experiencing its worst decline since its inception in 2010, as shown in the chart below.

A quick word on predictions

Fortunately, I’m not in the business of predicting the future. This is why my investment philosophy is not to rely often on my ability to predict what will happen next in the economy or the markets. Will inflation finally stabilize? Will the Fed raise interest rates more aggressively than expected? Will the economy grow as expected despite monetary tightening, ongoing supply chain challenges and geopolitical instability?

For what it’s worth, I believe the expansionary cycle that was supported by lavish monetary and fiscal stimuli in 2020 and part of last year is coming to an end. The cost of borrowing has increased sharply. consumer spending slowed down. Confidence has fallen in the United States and approached record lows elsewhere in the world. Expectations for global economic growth and profits have been hovering around 2008 levelsas they did during the worst of the COVID-19 crisis in 2020.

All of the above, coupled with the fact that Treasury prices are at the bottom of one of the worst bond sales in history, tells me that owning a fund like SCHO on the decline makes sense today. However, I don’t need to be right about my economic and market outlook to like this cash ETF.

Expect an annual return of 2% to 3%

Assuming there is no risk of default, short-dated US Treasuries are about as safe an investment as you can find in the market. This is the case because the future cash flows are known and the short time horizon means that the bonds are not heavily exposed to interest rate risk.

The scatterplot below shows how the two-year Treasury yield is very closely correlated (r-squared of +0.8) with the two-year expected return of a fund like SCHO – note: in order to Going back further in time in my analysis to the early 1990s, I used here the comparable Vanguard Short-Term Treasury Fund (VFISX) with an effective duration of 1.9 years as a proxy. The observation below is intuitive, consistent with the idea of ​​guaranteed future cash flows, and in no way dependent on economic or market cycles.

Therefore, the expected annual return of a fund like SCHO by the first half of 2024 should be very close to the yield of two-year Treasury bills, which is 2.7% today.

bearable risks

The recent environment of rapidly rising yields has caused Treasury prices to fluctuate more than usual. However, again due to the certainty of future cash flows and less exposure to interest rate risk, I do not expect SCHO to pose a material risk of loss to a portfolio or it produces unreasonably high levels of volatility.

Again, my beliefs are supported by historical data. The chart below shows that the rolling 12-month volatility of VFISX, my chosen proxy for SCHO, has generally hovered around 2% annualized (left axis). The risk measure has rarely exceeded 3%, even during periods of rising interest rates like 1994, 2005 and 2017-2018. The largest declines (right axis) have rarely exceeded 2%, with today’s all-time high selling likely best explained as a correction from the unusual surge in bond prices at the start of 2020.

The bottom line is that, given today’s very uncertain economic environment, I think a 2-3% annualized return over the next two years and volatility not expected to exceed 3% seem like a lot. I don’t think I can find better risk-adjusted performance in the markets, whether in fixed income, equities, commodities, or anywhere else.

Extra Credit: How to Improve Yields

Some may understandably feel that the low single-digit returns presented above may be a bit too modest for their goals and aspirations. One way to increase expected returns without taking disproportionate risks is to use leverage through deep-in-the-money call options.

Because the volatility in a fund like SCHO is so low, one can probably find a contract with very high deltas without having to pay too much premium. In this case, an investor can establish a leveraged position in SCHO by taking a long position in these derivatives.

Those who choose to go this route should pay attention to liquidity and bid-ask spreads to ensure that the options approach is not too costly and easy to set up.