It’s been a rough year for fixed income, the worst in modern history, yet it feels like things could be far worse. The $83 billion iShares Core US Aggregate Bond ETF (AGG) is down by 8.5% year to date, the largest decline in the 19-year history of the fund.
Similarly, the $45 billion Vanguard Total Intermediate-Term Corporate Bond ETF (VCIT) is lower by 10.6%, and the $21 billion iShares 7-10 Year Treasury Bond ETF (IEF) has lost 8.7%.
Sure, those are huge declines for investment-grade bond ETFs, but in the context of inflation running at more than 9%—the fastest pace since the 1980s—maybe it’s not that bad.
Think about it. As I type this, the 10-year Treasury bond yield is trading around 2.75%. That’s only 100 basis points higher than where it traded in March 2021, when high inflation wasn’t even on investors’ radars, and it’s the same place rates were in 2019.
Even the recent peak for the 10-year Treasury yield at around 3.5% isn’t that lofty. If investors were really concerned about persistently high inflation that lasts for years and years, that rate would be much more elevated.
As recently as 2007, just before the financial crisis, the 10-year Treasury yield was close to 5%. At the time, inflation was running at around 3%.
With consumer prices growing at three times that pace, it’s not hard to imagine interest rates could be much higher than they are today, and things could be much worse for bond ETFs, since bond prices and yields move inversely.
The fact that they aren’t is a reflection of bond traders’ expectations that high inflation will be relatively short-lived thanks to Fed rate hikes and a slowing economy, potentially even a recession. That assumption may or may not prove to be accurate, as almost everyone has been wrong about inflation so far.
If it is true, then bond investors really will have dodged a bullet and they can be thankful for only high-single-digit to low-double-digit declines—declines that would have been even smaller were rates not sitting near all-time-low levels last year.
After all, interest rates have only gone from “close to record lows” to “a higher but still low historically.” That’s a far cry from what could have potentially happened—or what could still yet happen.
Follow Sumit Roy on Twitter @sumitroy2