Bond ETFs On Track For Another Rough Year

You seldom see moves in the bond market as dramatic as the ones we’ve seen over the past few months.  

Shockingly high levels of inflation and the Fed’s hawkish pivot have pushed rates in the U.S. to their loftiest point in more than two years.  

In turn, bond ETFs of all stripes have been tumbling (bond prices and yields move inversely). The biggest of them all, the $89 billion iShares Core U.S. Aggregate Bond ETF (AGG), which holds a broad basket of investment-grade bonds, is down 3.9% year-to-date. 

But things could be worse. The 10-year Treasury bond yield, arguably the most important interest rate in the U.S., is still only around 2%, a level it hasn’t seen since mid-2019, yet far from the 3.25% high struck in 2018, at the end of the last rate hiking cycle.  

US 10-Year Treasury Bond Yield 

 
 

Indeed, with inflation at a 40-year high, the Fed still hasn’t hiked rates even once. And though calls for seven or eight rate hikes this year are growing, many central bank officials believe that a slower, more measured pace of rate hikes is warranted.  

There is also the popular view out there that inflation is primarily a result of impermanent supply chain issues related to the reopening of the economy rather than something monetary policy can fix.  

In other words, it’s plausible that bond prices would be much lower (and rates much higher) if investors believed that inflation was truly a chronic issue.  

So, yes, things could be worse for bonds and bond ETFs.  

First Back-To-Back Losses For ‘AGG’? 

I don’t mean to downplay the losses and volatility in the bond market. If the year ended here, it would be the first time that the aforementioned AGG delivered a negative total return in two consecutive years (it was down 1.8% in 2021). 

Other bond ETFs with more interest-rate sensitivity and/or credit risk have performed even worse: 

• The iShares 20+ Year Treasury Bond ETF (TLT) is down 7.7% in 2022 on top of a 4.6% loss in 2021 
• The iShares iBoxx USD Investment Grade Corporate Bond ETF (LQD) is down 6.5% after losing 1.8% in 2021 
• The iShares USD High Yield Corporate Bond ETF (HYG) is down 4.8% after gaining 0.9% in 2021 
• The iShares National Muni Bond ETF (MUB) is down 3.3% after gaining 1% in 2021 (it performed better than AGG in both periods)  

YTD Returns For TLT, LQD, HYG, MUB 
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These are pretty poor returns for ETFs that investors count on to deliver stability to their portfolios. Especially with stocks down 7.5% year-to-date (as measured by the S&P 500), the sting from these declines in bond ETFs is even greater. 

It’s a tough situation for investors. Inflation, the likes of which the country hasn’t seen in decades, has upended the traditional relationship between stocks and bonds.  

No one knows precisely how inflation will evolve and where rates will end up, but if inflation doesn’t quickly subside, it’s not unreasonable to think bonds could continue to go down in the coming months. 

Silver Lining  

Amid all the bond market uncertainty, one thing is true. Just as—all else equal—stocks are more attractive the lower they go, so too are bonds.  

And with bonds, the appeal is clear as day. Six months ago an investor in something like the iShares 7-10 Year Treasury Bond ETF (IEF) was getting a yield close to 1.25%; today, it’s closer to 2%. 

That’s a much bigger yield for new money invested. Sure, bond prices could go lower still, hurting the value of fixed income portfolios (at least temporarily)—but every incremental dollar you invest in fixed income today is generating a much higher return than you were getting six months or a year ago. 

That’s one silver lining of this rising rate environment.  

Follow Sumit Roy on Twitter @sumitroy2