‘Few Clear Signs’: 3 Words to Heed From the Fed

‘Few Clear Signs’: 3 Words to Heed From the Fed

Advisors best not ignore central bank warning that inflation remains a problem.

Reviewed by: Lisa Barr
Edited by: Ron Day

Fourth of July celebrations were no match for the fireworks that erupted a day later, when the Federal Reserve’s latest minutes were released. 

Financial advisors best not ignore three words from the report, which covered the goings-on at the Fed’s June 13-14 meeting, which featured the agency’s first rate pause since early 2022. 

A critical section of the announcement for both financial advisors and exchange-traded fund investors was the committee’s belief that there were “few clear signs” that inflation is on a path to declining toward its 2% target rate anytime soon.  

That opens the door for potentially higher interest rates, at a time when the economy may still not have fully reacted to the series of hikes already delivered.  

ETFs offer financial advisors a chance to target their exposure more earnestly to all types of bonds, especially those that flirt with high levels of “credit” risk. Simply put, for any corporation that has relied on cheap financing over the past decade, the prospect of higher rates is daunting.  

As investors found out in 2022, bonds can lose money too. Thus, advisors should recognize that while clients have come to expect stock market volatility, seeing their bond holdings collapse can be more unexpected, prompting more proactive communication. 

Bond ETFs 

Taken together, the three ETFs described below can help advisors create a picture of today’s bond market, its reward potential and its risks. History is littered with wealth destruction that stemmed from “reaching for yield” during a rising rate cycle. This is the investing equivalent of taking too much candy out of the candy jar. It satisfies, but then you get very ill. 

The startling rise in yields for very-short-term U.S. Treasury bills and notes might be temporary. So, an ETF like the iShares 3-7 Year Treasury Bond ETF (IEI) is a good baseline for a conversation about risk and reward in the world of bonds.  

IEI dates back to early 2007 and captures the total return of the medium-term Treasuries, so there is minimal perceived risk of default, recent Congressional debt ceiling drama notwithstanding. IEI’s current yield to maturity is 3.86%, a decent proxy for the noncredit-bond space. 

One step beyond is the iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD), which adds some credit risk by investing in corporate bonds, of which 46% are rated BBB. That’s the lowest “investment grade” rating, and investors demand compensation for that risk.  

LQD has an average maturity of 13 years, so the bonds it holds are subject to that credit risk for a while. LQD yields 5.39%, so advisors must gauge the trade-off with something like IEI here. In other words, clients are being adequately rewarded for stretching out in maturity and accepting much lower credit quality than U.S. Treasuries. At the current yield “spread” of around 1.5%, that’s a dicey call. 

The next step down the credit quality scale is captured via ETFs such as the SPDR Bloomberg High Yield Bond ETF (JNK), which invests mostly in bonds with a rating of BB or B, the heart of the “junk” category, with an average maturity of about five years. This $8.5 billion fund takes what LQD does, and as iconic chef Emeril Lagasse would say, kicks it up another notch. Its current yield to maturity of 8.65% is more than 3% above LQD’s, and nearly 5% higher than IEI’s.  

With the Fed’s signal that “few clear signs” exist to see an end to the upside risk to bond yields, and thus potential bond price declines, there has perhaps never been a better time for advisors to have a pivotal discussion about the trade-offs and workings of that other side of their stock market portfolio: bonds. 

Rob Isbitts was an investment advisor for 27 years before selling his practice to focus on ETF research and education. He is based in Weston, Florida. Contact him at  [email protected] and follow him on LinkedIn.