Should You Own Bond ETFs In 2017?

We're just a day away from the 5^th annual Inside Fixed Income conference, and Dave Nadig and I have been feverishly working on our keynote.

Dave and I try to take a fairly sophisticated approach to our talks. We've been researching investor behavior in fixed-income ETFs, examining the use of fixed-income ETFs by credit hedge funds, and gazing into the deepest nuances of ETF liquidity. We'll cover all that in our talk.

But despite the research, I keep coming back to a simple idea: Most investors are going to lose money holding bonds going forward.

Math & Fund Fees

Most people who say crazy things like that say them because they think interest rates are going to rise. After a 35-year bull market in interest rates, who can blame them? I have no idea where interest rates are going to go, and my challenge with bond portfolios has nothing to do with rates. Instead, it's math and fees.

In bond-land, the Bloomberg Barclays US Aggregate Bond Index is the equivalent of the S&P 500. It's the broad-based index that everyone uses as their benchmark and many use as the core of their portfolios.

The largest ETF tracking the Aggregate is the iShares Core U.S. Aggregate Bond ETF (AGG), which has $42 billion in assets and is virtually a perfect ETF. It charges just 0.05% in annual fees, trades like water and tracks its index perfectly. ETF.com rates it "A-98," which is pretty darn good.

Absent a crystal ball on rates, the best single predictor of the long-term return of a passive bond fund is its yield. After all, when you buy a bond and hold it, the best you can do is get your money back plus interest. In the case of AGG, the current distribution yield is 2.21%.

Costs Add Up

The problem with 2.21% is that, in an advised setting, you're almost guaranteed to lose money on a real basis. After all, according to the Bureau of Labor Statistics, the current Consumer Price Index is running at 1.5% per year; meanwhile, according to a survey of over 1,000 RIA firms in 2015, the average RIA firm charges a 1.03% annual client fee. Add them together and you get a 2.53% head wind for any held position.

That means you lose money, whether rates go up or stay the same. The only ways you break even or make money is if rates go down or if a lucky rebalance leads to you buying low and selling high.

There are a number of potential responses to this, and in my discussions in preparation for the conference, I've heard all of them. You could:

1. Accept the 1.18% after-fee absolute return on the basis that something is better than nothing.
2. Search for a lower-fee digital advisor given the lower future expected returns across your portfolio
3. Hold bonds or bondlike exposures outside of your advised assets, whether in a brokerage account or by using high-yielding CDs.
4. Diversify your bond portfolio into higher-yielding bonds.

The last thing is what we're seeing in ETF-land. The table below shows the 10 ETFs pulling in the largest amount of inflows through Sept. 30, 2016. While AGG still leads the charge, investors have poured billions into higher-yielding assets like corporates, emerging markets debt and high yield.

Bond investors face a lot of challenges in the year ahead.

With the Fed looking to boost rates at its December meeting, most of the warnings about what investors should do have focused on rising rates.

But even if rates stay the same, yields are so low that there are existential challenges to core bond exposures for advised assets. It'll be fun to discuss these and related challenges at Inside Fixed Income and on ETF.com in the year to come.

Matt Hougan is CEO of Inside ETFs, a division of Informa PLC. At the time of this writing, the author held none of the securities mentioned. He can be reached at [email protected].