Fed Policy Leaves Bond ETF Investors in Limbo

As the outlook for multiple interest rate cuts this year starts to look less likely with each passing inflation report, fixed income ETFs closely tied to Fed policy are taking their lumps.

The largest domestic exchange traded bond funds are lumbering into the second quarter as if rate cuts were never on the table, despite the year kicking off with expectations for as many as three interest rate cuts by year end.

Market watchers expect Wednesday’s consumer price index report to show core inflation still hovering around 3.7%, according to a Bloomberg survey. That's nearly double the Fed’s 2% target and not likely enough to justify a near-term rate cut.

“The longer the federal funds rate stays above 5%, the less attractive that Treasury bonds yielding less than 4.5% look,” etf.com Senior Analyst Sumit Roy said. Last week, expectations the Fed will further delay rate cuts helped pushed bond prices to their year-to-date lows, he said. 

Bond ETF Investors Stung by Fed Policy Pause

The yield on the closely watched 10-year Treasury is now closing in on 4.5%, which is a level not seen since November, suggesting the bond market is not convinced the Fed will move off its 5.25% overnight rate anytime soon.

For bond ETF investors who were expecting lower rates, the payoff hasn’t come yet due to the bond math of rates moving the opposite direction of bond prices.

The $104 billion iShares Core U.S. Aggregate Bond ETF (AGG) is down 1.7% this year despite leading the category in flows with $5.56 billion.

Right behind it in terms of flows is the $26 billion Vanguard Intermediate-Term Treasury Index ETF (VGIT), which is down 1.6% and has taken in $4.84 billion.

Then there’s the wildly popular $48 billion iShares 20+ Year Treasury Bond ETF (TLT), which is down 6.7% this year and has experienced $335.1 million worth of outflows.

“I don’t love anything in fixed income, and that’s almost always my feeling,” said Tim Holsworth, president of Midland, Mich.-based investment advisory firm AHP Financial. “We are keeping it short term for now, as those rates are more reliable and approaching 6%.”

Dan Pazar, executive vice president at the outsourced CIO firm for financial advisors Taiko in Chicago, still believes there are targeted opportunities in the bond markets.

“Pockets of the debt market make sense and seem fair while others are tight,” he said. “Within the structured market, you can move up in the capital stack and get similar yields with investment grade risk which seems like a good place to hide out without having the same concern over corporate defaults or spread widening.”