When it comes to fixed income, 2016 has been a tale of two halves.
For the first six months of the year, it was straight up for bonds―and straight down for interest rates, which move inversely with bond prices. Those first six months were characterized by a host of concerns: about China, Brexit and low oil prices.
Those worries—together with unprecedented monetary stimulus from the European Central Bank and the Bank of Japan—pushed yields on U.S. Treasurys to record lows, and yields on many bonds in Europe and Japan into negative territory. At one point this year, more than $13 trillion worth of bonds around the world were trading with negative yields.
But just when everyone began to think interest rates could only go down, the bond market reversed.
180 Degree Turn
Starting in July, interest rates started to tick higher slowly. Then in November, they exploded to the upside following the surprise victory of Donald Trump in the U.S. presidential election. Trump's policies of lower taxes and billions of dollars in infrastructure spending may translate into higher economic growth and higher inflation, two factors that tend to drive up interest rates.
Adding more fuel to the interest rate rise, this Wednesday the Federal Reserve hiked its benchmark overnight federal funds rate by 25 basis points―its second increase in the post-financial crisis era―and signaled that three more rate increases could be coming next year.
By the end of the day, the U.S. 10-year Treasury yield was trading as high as 2.59%, up substantially from its lows of 1.32% in July, and even up from where it started the year, at 2.27%.
U.S. 10-Year Treasury Yield
Roller-Coaster Ride For Fixed-Income ETFs
For investors in Treasury ETFs, it's been a roller-coaster ride—first with the big rally in bond prices (and decline in yields) and then the big plunge in bond prices (and rise in yields).
A chart of the Pimco 25+ Year Zero Coupon US Treasury Index ETF (ZROZ) tells the tale. With a weighted-average maturity of 27.3 years and no coupon payments, ZROZ is among the most-interest-rate sensitive ETFs on the market. At one point this year, it was up more than 30%. By Wednesday, it was down 1.5% on a year-to-date basis, making it the seventh-worst-performing fixed-income ETF of the year.
YTD Return For ZROZ
The chart for many fixed-income ETFs is similar: a big jump followed by a big swoon. The Vanguard Extended Duration Treasury Index Fund (EDV), which also holds zero coupon bonds, started the year strong but was down 1.5% year-to-date on Dec. 14, making it the eighth-worst-performing fixed-income ETF of 2016.
Even outside of Treasury ETFs, the pattern repeats.
Muni bond funds were up anywhere for 5-8% at their highs, but buckled in the past few months. Muni bonds ETFs are now among the worst-performing fixed-income products of the year, including the VanEck Vectors AMT-Free Intermediate Municipal Index ETF (ITM), down 1.9%; the Deutsche X-trackers Municipal Infrastructure Revenue Bond ETF (RVNU), down 1.5%; and the VanEck Vectors High-Yield Municipal Index ETF (HYD), down 1.3%.
YTD Returns For ITM, RVNU, HYD
Meanwhile, overseas fixed-income products haven't been immune from this year's volatility. The ProShares German Sovereign/Sub Sovereign ETF (GGOV) shed 1.2% year-to-date, making it the 10th-worst-performing fixed-income exchange-traded fund of the year.
Two China ETFs did even worse. The VanEck Vectors ChinaAMC China Bond ETF (CBON) and the KraneShares E Fund China Commercial Paper ETF (KCNY) lost 5.6% and 4.9%, respectively, making them this year's two worst-performing fixed-income ETFs.
“The [Chinese] bond market is overwhelmed by negative news from all sides, including surging U.S. Treasury yields, continuing regulatory tightening and rising inflation with improved economic fundamentals,” explained a Shanghai-based trader.
Junk Bonds' Big Comeback
With all that said, it hasn't been all bad for fixed income this year. While the big gains in many fixed-income ETFs have evaporated, the majority of products are still in the green for 2016. For example, the largest ETF in the space, the iShares Core U.S. Aggregate Bond ETF (AGG), was still up 1.5% as of Wednesday.
YTD Return For AGG
Moreover, there are a few big bright spots in fixed-income this year, such as junk bond ETFs. In fact, 18 of the top 20 fixed-income ETFs of 2016 are U.S. high-yield corporate bond funds. This is a segment of the fixed-income market that's been on a roller coaster of its own.
In January and February, junk bonds tanked amid fears that defaults by energy companies would spike as oil plunged as low as $26/barrel. But when oil prices recovered in the following months, so too did junk bonds.
The largest junk bond ETF, the iShares iBoxx $ High Yield Corporate Bond ETF (HYG), swung from a loss of almost 6% in February to a current gain of 12.2%. Even the recent plunge in Treasurys hasn't affected the recovery in junk bonds. HYG sold off briefly after the election, but quickly snapped back to its highs, pushing the spread between high-yield corporate bonds and Treasurys to an 18-month low.
HYG isn't even the best fixed-income ETF of the year. That title belongs to the VanEck Vectors Fallen Angel High Yield Bond ETF (ANGL), which surged 25.1% in the year-to-date period.
YTD Returns For HYG, ANGL
ANGL targets "fallen angels"—bonds that were recently downgraded from investment-grade to junk status. The hope is that the issuing company has merely fallen on temporary tough times, and that the bonds may be upgraded back into investment-grade status down the line. That strategy paid off handsomely in 2016.
ANGL's impressive return easily outpaced other junk bond ETFs, including the second-place ProShares High Yield-Interest Rate Hedged ETF (HYHG), up 16.4% this year. HYHG goes long junk bonds while simultaneously shorting Treasurys of equivalent duration to reduce interest rate risk.
Finally, emerging market bonds were another pocket of the fixed-income universe to perform well in 2016. Among those, the VanEck Vectors Emerging Markets High Yield Bond ETF (HYEM) and the iShares Emerging Markets High Yield Bond ETF (EMHY) did the best. Both funds hold dollar-denominated bonds, and gained 14.9% and 13.6%, respectively.
For a full list of this year's best- and worst-performing fixed-income ETFs, see the tables below:
Best-Performing Fixed-Income ETFs Of 2016 (Excluding Leveraged & Inverse)
Worst-Performing Fixed-Income ETFs Of 2016 (Excluding Leveraged & Inverse)
Data measures total return for the year-to-date period through Dec. 14.
Contact Sumit Roy at [email protected]