Coronavirus Fueling Bond ETF Gains

February 11, 2020

U.S. stocks may have largely shrugged off the deadly coronavirus and its impact on the global economy, but another asset class is doing no such thing. Rates on U.S. bonds have tumbled this year as investors flock to Treasuries and other bonds as a haven against the rapidly spreading global virus.

The benchmark 10-year Treasury bond yield fell as low as 1.5% earlier this month, its lowest level since September (bond prices and yields move inversely). At the same time, the 30-year Treasury yield briefly dipped below 2%, very close to its record low of 1.9% set in August.

ETFs tied to Treasury bonds, like the iShares 7-10 Year Treasury Bond ETF (IEF) and the iShares 20+ Year Treasury Bond ETF (TLT), returned 2.9% and 6.8%, respectively, so far this year. At the same time, the broader iShares Core U.S. Aggregate Bond ETF (AGG), the $73 billion behemoth, is up 1.9%.

10-Year Treasury Yield Falls Close To Record Lows

 

Bond Inflows Despite Positive Data

The fact that bonds are working yet again after years of outperformance has not gone unnoticed by investors. They plowed $20.7 billion into U.S. fixed income products so far in 2020, even as U.S. stocks hit record highs and U.S. economic data surprises to the upside.

On Friday, the Bureau of Labor Statistics reported that nonfarm payrolls expanded by 225,000; wages grew by 3.1% year over year; and the labor force participation rate rose to its highest level since 2013.

A few days before that, the Institute of Supply Management said its manufacturing gauge unexpectedly moved back into expansion territory, while its services gauge hit a five-month high. None of these data point to an imminent slowdown in the U.S. economy, and if anything, suggest the opposite—an acceleration.

But the bond market is not moving on these data points. It’s more focused on the latest developments with the coronavirus.

Coronavirus Surpasses SARS

By the latest tally, the coronavirus has infected 40,000 people worldwide and has killed 910, surpassing the death toll of 774 from the 2002-2003 SARS epidemic.

The virus, which originated in China and is doing most of its damage there, has brought the world’s second largest economy to a standstill. Analysts that said the country’s GDP growth could fall to zero this quarter if the virus continues to spread. That alone would be a major drag on the global economy, but if the coronavirus becomes more pervasive in other countries, the impact could be even more severe.

For now, investors don’t believe the virus’ impact will be anything but temporary and focused on China. That’s why U.S. stocks are at all-time highs.

But how do you reconcile that with Treasury rates, which are moving to uncomfortably low levels, suggesting a potentially bigger economic impact?

Explaining The Divergence

“Investors find themselves stuck between a rock and a hard place. U.S. economic data and corporate earnings are solid—supporting further gains in stocks,” explained Michael Arone, chief investment strategist at State Street Global Advisors. “But the yet unknown impact of the coronavirus on the global economy and the surreal U.S. political environment continues to fuel a push to hedge portfolios against additional volatility. This explains why stocks continue to touch all-time highs while yields remain depressed.”

Kevin Flanagan, head of Fixed Income Strategy for WisdomTree, agrees that fears of the unknown are spurring the demand for bonds.

“I don’t think the Treasury market is pricing in an adverse economic impact—yet. I look at this more as a flight-to-quality type of trade. It’s less economic-related and it’s more safe-haven-related,” he said.

Flanagan added that if investors were truly concerned about any economic damage, it would show up in credit spreads. Instead, credit spreads are well within their recent trading ranges.

Barbell Strategy

For now, it seems investors are content to use bonds as a hedge against any potential coronavirus impact, but as it relates to the U.S., they don’t expect that impact to be particularly large or long-lasting.

The Fed, which is on hold, is likely to stay on hold, though its next move—should it make one—would probably be a cut.

With that context, what should fixed income investors do?

WisdomTree’s Flanagan recommends a barbell approach using the WisdomTree Yield Enhanced U.S. Aggregate Bond Fund (AGGY) combined with the WisdomTree Floating Rate Treasury Fund (USFR).

After the recent drop in yields, “maybe you bring that barbell strategy down a bit in terms of duration. At the start of the year, with the 10-year Treasury over 1.9%, maybe you had a 70/30 allocation to the two. Now, with the 10-year yield down to 1.5%, maybe you’re moving to a 50/50 range,” Flanagan said.

While AGGY provides core bond exposure with solid 2.5% yield, it comes with interest rate risk. An allocation to the floating-rate USFR, which has almost no interest-rate risk, helps offset that exposure should rates suddenly rise.

‘Easy Money Has Been Made’

Meanwhile, State Street’s Arone warned investors that the easy gains in fixed income have likely already been made.

“Investors should never lose sight of the fact that bond allocations provide important diversification, capital preservation and income benefits to portfolios,” he said. “However, after last year’s bond market bonanza, most of the easy money from taking on additional duration and credit risk has already been made and the risks are heavily skewed to the downside.”

Arone’s tips include making certain that investors’ bond investments have a low correlation with their equity investments. In addition, they should attempt to match the duration profile of their bonds with their yields.

Lastly, “investors shouldn’t take on too much credit risk at this point in the cycle. Investments in mortgage-backed securities, short duration investment-grade corporate bonds and active bond managers with a conservative approach are prudent in today’s environment,” he concluded.

Email Sumit Roy at [email protected] or follow him on Twitter @sumitroy2

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