Mixed Risk About Bond ETFs

April 30, 2019

This is turning out to be an interesting year for asset allocators.

On one hand, the U.S. stock market is racing to new highs, buoyed by strong domestic economic data such as better-than-expected gross domestic product (GDP) figures for the first quarter of 3.2%, and a strong labor market.

All of this is good news for risk assets—S&P 500 ETFs such as the SPDR S&P 500 ETF Trust (SPY) are up 18% year-to-date.

On the other, there are signals aplenty pointing to potential trouble ahead.

For starters, outside the U.S., economic growth seems to be slowing. Weak economic data in Europe, Japan and China are all fueling concerns about potential contagion to the U.S. The possibility that global weakness spills over into our economy has the market now pricing an interest rate cut later this year—not a raise. The U.S. market is strong, but we may very well be headed into more easing by the Federal Reserve.

Red Flag: Tech Outperformance

Another sign of caution is the rise of the technology sector in long-term historical performance charts. According to research by Richard Bernstein Advisors (RBA), whenever cyclical sectors overtake defensive sectors such as health care and consumer staples in long-term performance—20-, 30-year performance charts—trouble may be brewing.

In recent weeks, technology has crossed above consumer staples in long-term performance, and is gunning for health care’s lead. (You can glimpse that performance by comparing Sector SPDRs such as the Technology Select Sector SPDR Fund (XLK), the Consumer Staples Select Sector SPDR Fund (XLP) and the Health Care Select Sector SPDR Fund (XLV) below.)

 

 

Consider the last time technology’s long-term performance peaked ahead of staples and health care was during the tech bubble in the early 2000s, RBA’s portfolio manager Dan Suzuki points out. Other examples of precedence here include when energy overtook these defensive sectors right before oil prices plummeted, and financials right before the credit bubble burst.

“Watch out when tech overtakes health care for the lead,” Suzuki said in a research note.

Bond ETF Investors In The Middle

This mixed bag of good and bad has bond ETF investors playing both sides in a way. In the past week, investors poured $2.1 billion into the safety of the iShares 20+ Year Treasury Bond ETF (TLT). The inflows came as 30-year Treasury yields dipped to two-plus-week lows as the market braces for a much less aggressive Fed.

The yield curve, which was inverted in late March, is now back in positive territory, with demand for longer-dated maturities rising. If you look at demand for Treasuries through a family of iShares ETFs, you see the demand is on the longer-dated funds.

Year-to-date, TLT has taken in more than $4 billion, while the iShares 7-10 Year Treasury Bond ETF (IEF) has seen $3 billion in net creations. On the flip side, the shorter-dated iShares 3-7 Year Treasury Bond ETF (IEI) and the iShares 1-3 Year Treasury Bond ETF (SHY) have been net losers of about $2.5 billion combined. (TLT took in $1.6 billion in 2018.)

 

Bond ETF Demand Trends

Flight to quality and safety in the form of longer-dated Treasury ETFs is only one place where investor demand is picking up.

The other place, perhaps surprisingly, is in corporate bond ETFs.

The iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) has taken in $1.3 billion year-to-date; and junk bond funds SPDR Bloomberg Barclays High Yield Bond ETF (JNK) and the iShares iBoxx USD High Yield Corporate Bond ETF (HYG) have seen net creations of $2.4 billion and $2.9 billion, respectively. These funds were all underperformers and net asset losers in 2018, but are now delivering solid gains and seeing strong asset growth.

The irony here is that bond investors are concerned about weak economic growth ahead, but are clearly unconcerned about companies’ ability to service their debt. They are bullish on corporate debt and on low default rates, pushing credit spreads over Treasuries down. 

 

Charts courtesy of StockCharts.com

 

Bond ETFs See Demand

So far, 2019 has been a great year for U.S. equities, but it has also been good for defensive assets such as bonds. Investors may be playing both sides given the mixed bag of what is (strong economy) and what may be (weaker growth ahead), but it all translates into massive asset flows in fixed income ETFs as an asset class.

Year-to-date, investors have poured some $36 billion into U.S.-listed fixed income ETFs, roughly half of all assets flowing into the ETF market this year, and more than the $25 billion in net creations seen in bond ETFs by this time last year.

 

Contact Cinthia Murphy at [email protected]

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