Introduction

Back in March 2023, we wrote an article on the Schwab Intermediate-Term U.S. Treasury ETF (NYSEARCA:SCHR). At that time, we pointed out that a meaningful rebound will likely not occur last year, and its fund price has indeed been in range bound. Since the macroeconomic environment is now quite different from last year, we think it is time for us to analyze SCHR again and provide our recommendations.

ETF Overview

SCHR has a portfolio of intermediate-term U.S. treasuries. Its fund price has been in range bound since 2023. The fund has a low expense ratio of 0.03%, has a weighted average maturity year of 5.6 years and a yield to maturity of 4.3%. We do not see much downside risk even in an economic recession, as U.S. treasuries are very safe compared to other types of bonds. Given U.S. inflation is likely already under control, we think there is potential upside if the Federal Reserve starts cutting the rate. Therefore, we think income investors may want to consider owning this fund.

Fund Analysis

SCHR has been in a range bound since 2023

Let us first review how SCHR has performed in the past 2 years. Following a sharp decline in its fund price in 2022 due to aggressive rate hike by the Federal Reserve, SCHR’s fund price has been in range bound. As can be seen from the chart below, SCHR’s fund price has stayed relatively the same since the beginning of 2023, declining by only 0.7%. Together with the fund’s dividend, its total return was about 4.1%.

As the chart above shows, SCHR’s fund price has swung within the range of about positive and negative 3%. This small volatility is primarily because the Federal Reserve has basically paused to hike the rate towards the second half of 2023. In addition, the fund’s weighted average maturity year of 5.6 years also makes its share price less sensitive to changes in rate than other longer-term treasury funds.

SCHR’s fund price has a strong inverse correlation to inflation and Fed fund rate

Inflation is an important factor that influences treasury rate and the treasury rate is directly related to SCHR’s share price. As can be seen from the chart below, SCHR’s fund price has an inverse correlation to U.S. inflation rate. This inverse correlation is quite obvious before mid-2022. However, the decline in U.S. inflation rate since mid-2022 is still not reflected in SCHR’s fund price. We have yet to see any meaningful jump in SCHR’s fund price.

Inflation is likely already under control

Although the current CPI rate of 3.3% is already much lower than the peak reached in mid-2022, we think the reason SCHR’s fund price has not moved up is due to the market’s fear that inflation will flare-up again. In addition, this rate appears to be still above the Federal Reserve’s long-term target of about 2%. Therefore, it is not difficult to understand why the Federal Reserve still needs to exercise caution and is not ready to cut the rate. If they moved too early to cut the rate, they risk letting inflation to come back again especially that inflation is a self-fulfilling prophecy. Therefore, the Federal Reserve may want to opt to keep the rate elevated for longer.

An important component and one of the primary growth drivers to the consumer price index (CPI) growth in the past two years has been the owner’s equivalent rent (OER). For reader’s information, OER growth rate was about 5.65% in May. This rate was much higher than the CPI rate of 3.3%. However, OER basically is a measure of what American homeowners could hypothetically charge to rent their own houses. Because most Americans are not renting their own properties, including an item like this could distort the CPI. If we exclude OER, the CPI would be down to near 2%. This is very close to the Federal Reserve’s long-term target. Hence, inflation is likely already under control. Therefore, we think the Federal Reserve will inevitably move to cut the rate.

An economic recession may still be in the horizon

We have pointed out that an economic recession may be in the horizon last year. However, the U.S. economy has proven to be more resilient than we thought, and a recession has not yet arrived. While a soft-landing may still be possible, the 10-year treasury rate minus 2-year treasury rate has turned negative for 2 years already. As can be seen from the chart below, this yield curve inversion has always happened first before an economic recession. In addition, we are observing a weakening labor market as unemployment rate steadily increased from 3.9% in April to 4.1% in June 2024. Therefore, we cannot rule out a possible economic recession arriving.

Fortunately, owners of SCHR should not fear for an economic recession as U.S. treasury has historically been considered a risk-free asset relative to other types of bonds (e.g. corporate bonds, or non-investment grade bonds). Therefore, in an economic recession, price of U.S. treasury can be quite resilient. As can be seen from the chart below, SCHR’s fund price stayed very firm even in the economic recession caused by COVID-19 in 2020. In contrast, SPDR Portfolio Intermediate Term Corporate Bond ETF (SPIB) and SPDR Portfolio High Yield Bond ETF (SPHY) declined quite significantly in 2020.

Investor Takeaway

SCHR currently has a yield of about 4.3%. The fund has limited downside risk in a possible upcoming recession, and has the potential for capital appreciation as inflation is clearly already under control. Therefore, we are willing to give SCHR a buy rating.