What to Do When Clients Demand Higher Bond Returns

So much about investing and modern markets can be misrepresented by simply reading past performance data. For instance, consider the following ETFs and trailing one-year total returns:

• The US Treasury 12 Month T-bill ETF (OBIL) returned 5.1%
• The iShares Aaa-A Rated Corporate Bond ETF (QLTA) returned 6.0%
• The iShares BBB Rated Corporate Bond ETF (LQDB) returned 7.7%
• The iShares BB Rated Corporate Bond ETF (HYBB) returned 11.2%

At first glance, a financial advisor facing a client in a meeting would probably expect to hear something like, “Why don’t we invest in HYBB?” And they’d have a point. Sort of.  

Because these are not normal times for investors looking to beat Treasury bills, but without taking on equity-like risk. As they say, it’s complicated. Let’s try to make it less so.

The Federal Reserve raised interest rates 11 times during 2022 and 2023. This caused rates on bonds across the spectrum to rise. Short-term US Treasuries, considered to be the safest bonds on the market, saw their yields rise from near zero to over 5%. And while historically that rate perch would not last too long, even when the inflation spike that contributed to it quickly reversed, this is not our parents’ bond market.

Credit Risk and Couch Potatoes

So, we remain with T-bills in the 5% range. That’s mighty competitive for what is the investor and advisor version of being a couch potato. Long term rates, by contrast, have been making their impression of an NFL punt returner, who runs 50 yards in several directions to evade tacklers, only to end up at the same yard line where he caught the ball in the first place. 

Intermediate term and long-term bond rates have been caught in a trading range. If that range becomes the “new normal” it could tempt investors to settle in there for a while.  

As those ETF returns imply, the past 12 months have been an opportunity to make some price return on top of their coupon interest payments, which in ETFs are paid out as regular dividends. The A-rated and BBB-rated ETFs noted above delivered yields either side of 4% in the past 12 months, below that of the one-year T-bill ETF (OBIL) which produced a 5% couch potato return.

And the BB-rated ETF yielded 6%, which makes sense considering that it is a “junk” bond fund. And, while the total returns noted above for the three “credit bond” (not US Treasury) ETFs cited might look enticing, they could be a mirage.  

That’s because rates did drop over the past 12 months, before settling in more recently. That produces a price gain on the bond ETFs above and beyond the dividend payout. And as noted, that is all in the past.

What advisors and investors need to keep front-of-mind at this point in the bond market cycle is that as with past eras, conditions that exist today have at least the potential for panic to set into the credit bond markets. Reaching for yield, either by owning ETFs with longer-term bonds, lower credit ratings or both, can be rewarding activity. That is, if the market continues to favor them.  

Unfortunately, credit markets can be fickle beasts, and the key decision is always about how much yield “premium” is worth reaching for. Many issuers of lower-quality bonds are in danger of having to refinance those bonds at higher rates, particular from 2025-2027, as a deluge of lesser-quality debt issued at formerly low rates comes due. That is a predicament this generation of investors has yet to have to confront.  

Assess, Don't Guess

And maybe they won’t. We don’t know where rates will go, but if they plunge over the next year, that may allow investors in credit bond ETFs to profit more. Or, if a recession is the culprit for the Fed lowering rates quickly, that could help A-AAA rated bonds and Treasuries, but crush lower quality corporate bonds, as so-called yield spread quickly explode higher. In other words, the rate the market will require to own those bonds might go up several percentage points, with a commensurate drop in the prices of those bonds and therefore the bond ETFs that hold them.

None of these lands on a “do this or do that” type of answer. Because every investor is different, and if they have an advisor, that advisor is paid to know that client’s goals and emotions about money intimately. This has merely been a call to action for advisors and self-directed investors to focus on what has happened, consider that when it comes to credit bonds, the markets are coming off a position of strength, but that a wide range of potential outcomes awaits.  

Reward and risk. That’s investing. And when it comes to credit bonds in mid-2024, it sets up some very intriguing choices. No matter how you slice the potato.